ITEM 1. BUSINESS
Overview
Sohu is one of the premier Internet media companies in China, providing millions of Chinese consumers with their daily source of information, entertainment and communication. We have built one of the most comprehensive matrices of Chinese language Web properties consisting of:
•
www.sohu.com, a leading mass portal and online media destination;
•
www.sogou.com, an interactive proprietary search engine with an expanded database capacity of more than ten billion retrieved web pages;
•
www.17173.com, a leading games information portal;
•
www.focus.cn, a top real estate Website;
•
www.chinaren.com, a leading online alumni club;
•
www.go2map.com, one of the leading online mapping service providers; and
•
www.goodfeel.com.cn, a wireless value-added services provider.
Sohu corporate services consist of brand advertising on its matrix of Websites as well as paid listing and bid listing on its in-house developed search directory and engines. Sohu also offers two types of consumer services, which includes online game and wireless. The company operates two massively multi-player online role-playing games (or MMORPG games), namely Tian Long Ba Bu (or TLBB) and Blade Online (or BO), and a casual game platform. Sohu also offers wireless value-added services such as news, information, music, ringtone and picture content sent over mobile phones.
We were incorporated in Delaware in August 1996 as Internet Technologies China Incorporated, and launched our original Website, itc.com.cn, in January 1997. During 1997, we developed the Sohu online directory and search engine and related technology infrastructure, and also focused on recruiting personnel, raising capital and aggregating content to attract and retain users. In February 1998, we re-launched our Website under the domain name Sohu.com and, in September 1999, we renamed our company Sohu.com Inc. On October 18, 2000, we completed the acquisition of ChinaRen, the leading youth community Website in China. On
November 24, 2003, we completed the acquisition of Kylie Enterprises Limited, the owner of 17173.com, a Website providing information about multiplayer online games in China. On November 25, 2003, we completed the acquisition of All Honest International Limited, the owner of Focus.cn, a Website providing information about real estate in Beijing and Shanghai. On May 31, 2004, we completed the acquisition of Marvel Hero Limited and Goodfeel, a leading provider of value-added mobile data services for Wireless Application Protocol, or WAP, in China. On May 31, 2005, we completed the acquisition of Go2Map Inc. (and its affiliate, Tu Xing Tian Xia), one of the leading online mapping service providers in China. On November 1, 2006, we completed the acquisition of 21 East HK and its subsidiary 21 East Beijing, an entertainment provider in China. Through our acquisition and successful integration of these companies, we have built one of the most comprehensive networks of Web properties in China.
Substantially all of our operations are conducted through our indirect wholly owned PRC subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age and our VIEs, High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information, 21 East Beijing, Gamease Age and New 21 East. Since our inception, our business model has expanded to include other major business lines, including brand advertising, sponsored search, online game, wireless services and other businesses.
We derive revenues from the sale of brand advertising, sponsored search, online game and wireless services.
In 2000, we started the e-commerce business, selling consumer products through store.sohu.com. We discontinued the e-commerce business on June 20, 2006 in order to focus on profitable segments. In 2001, we began to provide wireless services for mobile phone users through sms.sohu.com. We then expanded our wireless services to include short messaging services, or SMS, Ring Back Tone, or RBT, WAP, multimedia messaging services, or MMS and interactive voice response, or IVR. In 2003, we launched our first licensed multiplayer online game, Knight Online (or KO). Because the license to KO expired in November 2006, we discontinued the operation of the game since then. In 2004, we launched our second multiplayer online game, BO. In May 2007, we launched our first self-developed multiplayer online game, TLBB. In August 2004, developed from the existing directory search capabilities, we introduced our new, all-inclusive, proprietary search engine under the brand name Sogou through Sogou.com. On January 1, 2007, we announced the launch of Sogou version 3.0, which offers further enhanced updating speeds, shortened search times and more accurate search results, based on an expanded database capacity of more than ten billion retrieved web pages.
Official Internet Content Service Sponsor for Beijing 2008 Olympic Games
In November 2005, we were selected as the official sponsor of Internet Content Services (or ICS) for the Beijing 2008 Olympic Games. Under the sponsorship agreement we entered into with the Beijing Organizing Committee for the Games of the XXIX Olympiad (or BOCOG), we provided exclusive services to BOCOG to construct, operate and host the official BOCOG Website, www.beijing2008.com, for this historic event.
Our Web Properties
We have matrices of seven Web properties, with Sohu.com being the Website attracting the highest level of Internet traffic. On all of our Websites, we offer basic content to our users on a free of charge basis.
Mass Portal-Sohu.com
Sohu.com’s portal consists of sophisticated Chinese language Web navigational capabilities, 35 main content channels, Web-based communication and community services and short messaging services. Each of our interest-specific main channels contains multi-level sub-channels that cover a comprehensive range of topics, including news, business and finance, entertainment, sports, information technology, automobile, real estate, and women. We also offer free Web-based e-mail services. Our portal attracts consumers and merchants alike because it is designed to meet the specific needs and interests of Internet users in China. Key features of our portal include proprietary Web navigational capabilities that reflect particular cultural characteristics and viewing habits of PRC Internet users.
Proprietary Search Engine-Sogou.com
Sogou, which means “Search Dog”, is Sohu’s proprietary search engine launched in August 2004. Sogou performs interactive searches of billions of Web pages using advanced algorithms. The user is taken through a fast and convenient interactive process to arrive at the most relevant selection of the integrated Website and page search results. On February 25, 2005, we launched our upgraded search engine Sogou 2.0 with an expanded breadth of one billion Chinese language indexed web pages, higher updating speed and shorter search time. In November 2005, we announced the launch of Sogou version 2.5, a further upgrade for our proprietary search engine. This upgraded Sogou 2.5 was more sophisticated with advanced spider technology and more intelligent in terms of crawling, selecting and ranking capabilities so as to provide more relevant, accurate and up-to-date Web search results. On January 1, 2007, we announced the launch of Sogou 3.0, a newly upgraded version for our intelligent search engine. This new version of Sogou can provide our users with higher updating speeds, shortened search times and more accurate search results based on an
expanded database capacity of more than ten billion retrieved pages. We will continue to integrate Sogou 3.0 with the content strength of our comprehensive Internet platform and our community based product offering, which will enable us to obtain knowledge of our users’ online habits and interests, in order to optimize the overall search experience for our users.
Vertical Sites
17173.com
The Sohu games portal www.17173.com was launched in 2000 as the first online games portal in China and was acquired by Sohu in November 2003. 17173.com is a leading online destination for game players seeking information on games and feedback from other players on the site’s message boards. With over 100 game zones and millions of registered users supported by alliances with over thousands of Internet cafés, 17173.com is one of the largest online games information and community Websites in China. The games portal www.17173.com is widely recognized as a market leader among the games Websites in China, with strong expertise in running the Website, building a game community and developing relationships with advertising clients in the online games industry.
Focus.cn
Focus.cn is one of the leading real estate Websites in China. Focus.cn attracts many users who are homeowners with high incomes and real estate professionals. Launched in 1999, Focus.cn has developed into what we believe is one of the most influential Websites serving the Beijing market. The Focus.cn platform serves as a basis for regional expansion in other key urban areas where Internet penetration is highest in China. As of December 31, 2007, the Website has successfully rolled out into 28 cities. Focus has also been enriching its content and has diversified from residential properties to commercial properties, as well as other auxiliary industries, such as home decoration, furniture and fixtures.
Chinaren.com
We acquired ChinaRen in October 2000. ChinaRen is the largest online youth community in China, with over eighty million registered users as of December 31, 2007. Schools and universities in China generally do not have alumni offices to cater to the needs of former students to organize their classes into long-term communities. As in other Asian societies, Chinese people hold strong ties of friendship and loyalty with their fellow alumni, which form the basis of their personal and professional relationship networks. ChinaRen has leveraged a critical mass of loyal users to create one of the leading online alumni networks in China.
Go2Map.com
Go2Map is one of the leading online mapping services providers in China founded in 1999. Go2Map mapping information platform enables online mapping services through different Internet/Intranet platforms, mobile phones, call centers and PDAs. Go2Map’s database covers points of interests in more than 307 cities across China, which has enabled it to develop multiple business applications, including sales of software and map information resources. Go2Map also provides Web surfers a free online mapping inquiry system in large Chinese cities. We acquired Go2Map in May 2005 and Go2Map’s expertise in professional location-based information had enhanced our search engine capabilities as well as online Website content.
Goodfeel.com.cn
Goodfeel is a leading WAP service provider in China, offering various WAP services including ring tone and picture downloads. Goodfeel.com was founded in November 2001 and was acquired by us in May 2004. Goodfeel has since been integrated with our WAP business. We believe it is important for Sohu to maintain a presence on the wireless side, and more specifically in WAP, in anticipation of the launch of the third generation of mobile networks in China in the near future and the burgeoning market that it will bring.
Our Products and Services
Products and Services for Businesses
Brand Advertising
In brand advertising, we enjoy a strong competitive position as one of the top portals in China. We provide brand advertising services across our matrices of Web properties. Our offerings enable advertisers to post their advertisements in different forms, including textual, rich media and graphic advertisements, and in different locations on the Sohu matrix of Web properties. Our brand advertising products include but are not limited to banners, links, logos, buttons and stream advertisements placed on our Websites
and sponsorships that typically focus on a particular event or a particular Website area. We charge advertisers daily or hourly rates for banners, links, logos, buttons and stream advertisements. Sponsorship contracts for a particular area of a Website or for a particular event may require fixed payments over the contract period. Our standard advertising charges vary depending on the terms of the contract and the advertisement’s location within our Website. Discounts from standard rates are typically provided for higher-volume, longer-term advertising contracts, and may be provided for promotional purposes.
We rely on both direct sales by our internal sales force and sales by advertising agents for advertising on our Websites. During the year ended December 31, 2007, approximately 1,070 companies advertised on our Websites. Our customers include multinational companies that have significant operations in Chinese markets, many of which are Fortune 500 companies, as well as numerous Chinese domestic companies, which are mainly large or medium size companies. We plan to continue focusing on multinational and Chinese domestic companies as our key advertisers. In 2007, our five largest advertisers accounted for approximately 14% of total brand advertising revenues. Sohu has entered into agreements with each of these advertisers. Most of these agreements have terms of less than 12 months.
The focus of our marketing strategy is to generate brand and product awareness for Sohu.com in China with advertisers, Internet users and the general public. During the year ended December 31, 2007, we spent approximately $22.5 million in advertising expenses. As a pioneer of the PRC Internet industry, we have been able to generate substantial public awareness of Sohu in China.
As of December 31, 2007, we had obligations to provide, and advertisers had obligations to purchase, advertising services under existing contracts in the amount of $2.3 million, of which $1.8 million of services were required to be provided during the year ended December 31, 2008.
Sponsored Search
We offer a series of sponsored search offerings, aiming at small and medium sized enterprises that pay fees to list on our search results, in our directory. Through our sponsored search services, we provide advertisers a cost-effective way to deliver advertisement to targeted customers by displaying advertisements in response to user actions, such as a keyword search. We offer both paid listing and bid listing on our search engine and online directory, as well as listings in our classified advertisement section. For paid listing, advertisers pay fixed lump-sum fees based on priority and keywords within a certain period. For bid listing, advertisers pay us according to a cost per click bidding price set by the advertisers.
We market our paid search services through the use of approximately 200 distribution agents as well as our internal sales force. We also have a Website Alliance network with more than 6,000 members, whereby our bid listing advertisers could choose to also post their links in different Websites of the Website Alliance members so as to increase the chance of click-through.
In 2007, we had more than 51,400 customers for our sponsored search business.
Products and Services for Users
We provide an array of products and services to our users through our Web properties, including aggregated content, communication and community, search and directory, online game and wireless services.
Aggregated Content
We also are a leading aggregator of content, and provide content on a variety of topics. We organize our content around 35 main channels on the Sohu portal. Each main channel contains numerous sub-channels and features news, commentaries and various utilities and solutions relating to a specific topic. We also have regional Websites in three different cities in China. As of December 31, 2007, we had over 1,600 content partners, which enables us to provide a wide range of content offerings. Our content partners are leading Chinese language media and information providers in a variety of fields with coverage of major cities in China. Our arrangements with content partners are normally short-term and non-exclusive. In addition, we have established exclusive partnership/sponsorships with some of our important content partners and sponsors, including the Beijing 2008 Olympic Games, Team China, China Interactive Sports and NBA. Such exclusive content partnerships or sponsorships enable us to differentiate our brand advertising offering from other brands and to improve and strengthen our brand.
All of our channels, including co-branded third party content on our portal, are defined by the following features, that together constitute the distinct Sohu “look and feel”: the Sohu.com logo, the “Search Fox” mascot that displays different postures in different channels, the navigation bar, the color combination, the size and type of the Chinese characters, the spacing of the characters used in our directories and the reporting style. Below are descriptions of some of our main channels:
News
Delivers a comprehensive selection of local, national and international news from newspapers, magazines and other information providers throughout China. Full text search is also available on each page.
Business and Finance
Features business and financial news provided by leading financial information services in China covering both domestic and international markets. Users can retrieve real-time stock quotes, fund price, exchange rates, annual reports, research reports and other information on selected listed companies in China.
Entertainment
Contains extensive coverage of entertainment arenas that are of interest to Chinese users, including movies, television programs, plays, operas and popular and classical music.
Sports
Provides the latest in national and international sports headlines, results, commentaries and analyses as well as exclusive contents obtained from exclusive partners, such as NBA, Team China Football and Team China Basketball. Provides broad coverage on news, events and information surrounding the Olympic Games and Team China.
Information Technology
Includes industry forums, industry policies and trends, and online communications with the CEOs of the top Chinese companies in the information technology industry. Features information technology news, product reviews and software downloads.
Automobile
Includes industry forums, industry policies and trends, and online communications with the CEOs of the top Chinese automakers. Also provides automobile features, news, and product previews.
Real Estate
Together with Focus.cn, this channel offers directories of apartment, residential housing and commercial housing listings in major cities in China, and publishes advice and information on general real estate and home furnishing matters.
Women
Covers a broad range of lifestyle-related topics that are of particular interest to Chinese women, including fashion and trends, beauty, society, emotion and other areas.
Streaming Online Videos
In addition to providing traditional text and picture-based content, we have focused on developing new media technologies. We have launched online TV-like channels, such as V.Sohu for entertainment, S.Sohu for sports and TV.Sohu for TV programs, specifically geared for video content. In addition to watching pre-set programs with broadcasting schedules, users can also enjoy certain programs on an on-demand basis.
Communication and Community Tools
We offer a variety of communication and community tools for our Chinese online users that are important in promoting user affinity to our portal network:
Alumni Club
Alumni Club is a database service containing information on schools, classes and classmates that allows classmates to communicate and find each other. As of December 31, 2007, there were over eighty million registered users.
Blogs
Blogs in an interactive platform for users to build their own space by posting their articles and pictures, uploading videos, and allow sharing of information amongst users. Further, Sohu blog provide unique facility for personalized blog’s front page layout, interactive communication facilities for blog users and services integrated with a selection of Sohu products. In January 2008, we opened the development platform on Sohu Blogs to all third-party developers through “open widget”, through which, developers could rapidly develop and distribute their widgets to massive Sohu bloggers on Sohu’s platform. Sohu bloggers can choose any of such widgets and apply them to their blogs according to their own preference.
E-Mail
We offer e-mail services to our users with up to two-gigabyte free memory.
Picture Gallery
Offers users to post their favorite pictures and allows interaction with other users. Organizes the collected pictures in categories and offers searching function to users for locating different pictures.
Message Boards
Users can post and exchange information on message boards covering 16 main topics, ranging from education and travel to fashion, sports and all news web pages.
Web Messenger
Our web-based messenger enable Sohu registers to communicate with other users freely by sending instant messages to registers throughout the Sohu matrix.
Search and Directory Services
In 1997, we started as China’s first online search company under the brand, Sohu, which means Search Fox in Chinese, and have continuously developed our in-house search technology. In 2004, we launched our search brand, Sogou, which means Search Dog in Chinese. Currently, we provide both keyword search services and search directory services to our users. Under the keyword search, the end users type in the keyword in the search box on the Website, and a list of Website links related to the searched keyword will be shown as search results. The search directory is structured as a search engine by categories. The end users can choose the search type from the nine categories and are linked to the corresponding Websites to continue the search process.
Over the years, our in-house directory of Websites has been continuously expanding. With a search database of more than ten billion retrieved web pages, we believe Sohu has one of the world’s largest Chinese language online search databases. We offer our users the following search services:
Web Page Search
Our Web Page Search is based on our latest search technology, with an expanded database capacity of more than ten billion retrieved web pages. Our web page search provides users a better experience by increasing updating speed and higher relevancy for search results.
Music Search
Music Search enables people to easily find music, songs, lyrics, ring tones and other multimedia files on the Internet. The users can also sort our Music Search links by various categories, such as lists of top pop songs and singers, which are updated automatically every week based on the number of clicks.
News Search
Our News Search gathers information from over 2,000 sources, provides links to local, national and international news which are updated every minute.
Say Board
Our Say Board provides users with a query-based searchable community to exchange views and share knowledge and experiences. Users can search, read and browse Internet message boards and post messages.
Picture Search
Picture Search enables users a convenient method to search for relevant pictures by keywords.
Map Search
Map Search helps users search for maps, get directions, and find locations quickly and easily within China.
Online Games
In 2007, we operated two MMORPG games, namely TLBB and BO.
TLBB
TLBB is our first in-house developed MMORPG game with development work started in late 2004. It is a 2.5D martial art game based on a famous novel “Eight Demigods” written by Louis Cha. The game appeals to players of all levels and offers high quality graphics and in-game communities. In the interactive in-game communities, the players can complete series activities, such as making friends, getting married, learning life skills or completing other preset tasks. To enhance the game experience, users can buy in-game virtual items, such as power enabled medicine, costumes, weapon by purchasing Sohu prepaid cards and charge the amount to their accounts. TLBB was commercially launched in May 2007 and solidified its success during the subsequent months during the year of 2007. As of December 31, 2007, TLBB has been ranked in the top five MMORPG games in the Chinese market. The success of TLBB in China has enabled us to license the game overseas. In August 2007, we licensed TLBB to an operator in Vietnam. In December 2007, we also licensed it to operators in Hong Kong and Taiwan. As of December 31, 2007, TLBB had more than 23 million registered users in China.
BO
In 2004, we launched BO, which was co-developed with a Beijing-based game studio. In December 2006, we launched Blade Hero Online, which is the upgraded version of BO.
In 2007, both games are free-to-play games and generate revenue through sale of in-game virtual items. Under this item-based model, players play a game on a free of charge basis and with the ability to purchase in-game premium features. The item-based model allows us to make frequent adjustments to meet the changing demands of players in order to enhance game interaction and create a better game community. In addition, the item-based model offers flexible ways to generate revenues, including attracting more users, increasing the number of active paying accounts and growing average quarterly revenue per active paying account (or ARPU). Online game revenues are collected through sale of our prepaid cards, which we sell in both virtual and physical form, to third party distributors and retailers.
Pipeline
In August 2007, we obtained rights to develop the game “The Duke of Mount Deer”, another famous novel written by Mr. Louis Cha, author of TLBB. This will be a 2.5D cartoon style MMORPG game and is now under development. In December 2007, we licensed a new MMORPG game, “The Legend of the Ancient World,” from a local studio. This will be a 2.5D MMORPG game and is now under development.
Casual Game
In addition to MMORPG games, we also operate a casual game platform on our portal, which mainly consists of 40 casual games, such as chess, board games, card games and puzzle games. In 2007, no revenue was generated from this casual game platform.
Wireless Services
We operate as a service provider to China’s leading mobile network operators, offering a wide range of wireless products focused on entertainment, information and communications. These products are available to end users via a broad choice of technologies, such as SMS, RBT, WAP, MMS, and IVR services. We provide wireless services mainly pursuant to our cooperation arrangements with all of the four Chinese mobile network operators and their provincial subsidiaries.
We offer a variety of products and services to our users by utilizing the content of our portals to create fee-based services. Users can purchase our wireless services through our Websites or through mobile phones and pay for such services on a monthly subscription basis or per-message basis. Users may subscribe to receive news, alerts and other information, download ring tones and logos and alumni clubs, participate in dating and friends matching as well as play games, and order other mobile related content. Pursuant to our cooperation arrangement with mobile network operators, the monthly service fees charged on users range from $0.065 to $4.037 per month and single message fees range from $0.006 to $0.538 per message. For the year ended December 31, 2007, approximately 59% of our SMS revenues was derived from consumers who subscribe for monthly services. We do not directly bill and collect fees from users. Instead, we rely on mobile network operators to bill and collect our service fees. After collecting service fees from users on behalf of Sohu, mobile network operators will deduct a percentage of such revenue as gateway fees and service fees before paying the balance to us. Such percentages normally ranges from 15%-60% based on contract rates.
Competition
The Internet and Internet-related markets in China are relatively new and rapidly evolving. There are many companies in the domestic and international markets that distribute online content, value-added telecommunications services targeting Chinese users. We now are facing more intense competition from both domestic and international competitors for providing content and services over the Internet, including brand advertising, content, community tools, search engines, web directories, online games and wireless services. For example, there are a number of existing or new PRC Internet portals, including those controlled or sponsored by private and PRC government entities. As an Internet portal, we compete with these portals, including but not limited to Sina, Tencent and Netease, and vertical sites, such as PColine and SouFun. Our search engine faces intense competition from software and other Internet products and services incorporating search and retrieval capabilities, such as Baidu, Google, Yahoo! China and SoSo. We compete with other pure-play online games developers and operators including but not limited to Shanda, The9, Perfect World, Giant Interactive, Netdragon and Kingsoft; and pure-play wireless services providers, such as Tom Online, KongZhong, Linktone and Hurray!. In addition, we compete with operators of global leading Websites or Internet service providers, including Yahoo!, Microsoft/MSN and AOL, currently offer, and could expand, their online products and services targeting China. These sites and companies compete with us for visitor traffic, advertising dollars, Internet services, game players spending, wireless services and potential partners.
In the PRC Internet market, competition is intense and is expected to increase significantly in the future because there are no substantial barriers to entry in our market. Our competitors may have certain competitive advantages over us in terms of:
•
substantially greater financial and technical resources;
•
more extensive and well developed marketing and sales networks;
•
better access to original content and information;
•
greater global brand recognition among consumers; and
•
larger customer bases.
We compete with other portals in China primarily on the following basis:
•
technological advancements;
•
attractiveness of products;
•
brand recognition;
•
volume of traffic and users;
•
quality of our Websites and content;
•
strategic relationships;
•
quality of our services;
•
effectiveness of sales and marketing efforts;
•
talented staff; and
•
price.
Our existing competitors may in the future achieve greater market acceptance and gain additional market share. It is also possible that new competitors may emerge and acquire significant market share. We believe the rapid increase in China’s online population will draw more attention from these multinational players to the PRC Internet market. We also compete with traditional forms of media - such as newspapers, magazines, radio and television - for advertisers, advertising revenues and content. Some of these traditional media have extended their businesses into the Internet market such as CCTV.com and XinHuaNet. Accordingly, we will face more intense competition with traditional media companies in both their traditional media, and in the Internet-related markets.
Government Regulation and Legal Uncertainties
The following description of PRC laws and regulations is based upon the opinions of TransAsia Lawyers, our PRC counsel. For a description of legal risks relating to our ownership structure and business, see “Risk Factors.”
Regulatory Authorities
Certain areas related to the Internet, such as telecommunications, Internet information services, international connections to computer information networks, information security and censorship are covered extensively by a number of existing laws and regulations issued by various PRC governmental authorities, including:
•
the Ministry of Information Industry, or MII (formerly the Ministry of Post and Telecommunications, or MPT);
•
the Ministry of Culture, or MOC;
•
the Ministry of Public Security;
•
the State Administration of Industry and Commerce, or State AIC;
•
the General Administration for Press and Publication, or GAPP (formerly the State Press and Publications Administration, or SPPA);
•
the State Administration for Radio, Film and Television, or SARFT; and
•
the State Council Information Office, or SCIO.
Telecommunications Laws and Regulations
Among all of the applicable laws and regulations, the Telecommunications Regulations of the People’s Republic of China, or the Telecom Regulations, implemented on September 25, 2000, is the primary governing law, and sets out the general framework for the provision of telecommunication services by domestic PRC companies. Under the Telecom Regulations, it is a requirement that telecommunications service providers procure operating licenses prior to their commencement of operations. The Telecom
Regulations draw a distinction between “basic telecommunications services” and “value-added telecommunications services”. Value-added telecommunications services are defined as telecommunications and information services provided through public networks. A “Catalogue of Telecommunications Business” was issued as an attachment to the Telecom Regulations to categorize telecommunications services as basic or value-added. In February 2003, the Catalogue was updated, categorizing online data and transaction processing, on-demand voice and image communications, domestic Internet virtual private networks, Internet data centers, message storage and forwarding (including voice mailbox, e-mail and online fax services), call centers, Internet access, and online information and data search as value-added telecommunications services. Accordingly, there are various types of telecommunications services, in which Sohu is engaged that are regulated as value-added telecommunications services.
Foreign direct investment in telecommunications companies in China is regulated by the Regulations for the Administration of Foreign-Invested Telecommunications Enterprises, or the FITE Regulations, which were issued by the PRC State Council on December 11, 2001, and became effective on January 1, 2002. The FITE Regulations stipulate that telecommunications enterprises in the PRC with foreign investors, or FITEs, must be established as Sino-foreign equity joint ventures. FITEs can undertake operations in basic telecommunications services and value-added telecommunications services. Under the FITE Regulations and in accordance with WTO-related agreements, the foreign party to an FITE engaging in value-added telecommunications services may hold up to 50% of the equity of the FITE, with no geographic restrictions on its operations. The PRC government has not made any further commitment to liberalize its regulation of FITEs.
In view of the restrictions on foreign direct investment in the telecommunications sector, we established several domestic Variable Interest Entities, or VIEs, to engage in value-added telecommunications services. For a detailed discussion of our VIEs, please refer to below “Our PRC Corporate Structure”. In view of the FITE Regulations and Sino-Foreign Equity Joint Venture Law, we may consider establishing a foreign-invested telecom entity at an appropriate time.
On December 26, 2001, the MII promulgated the Administrative Measures for Telecommunications Business Operating Licenses, or Telecom License Measures, to supplement the Telecom Regulations. The Telecom License Measures confirm that there are two types of telecom operating licenses for operators in China (including FITEs), namely, licenses for basic telecommunications services and licenses for value-added telecommunications services. With respect to the latter, a distinction is made as to whether a license is granted for intra-provincial or “trans-regional” (inter-provincial) activities. An appendix to the license will detail the permitted activities of the enterprise to which it was granted. An approved telecommunication services operator must conduct its business (whether basic or value-added) in accordance with the specifications recorded on its Telecommunications Services Operating License.
On August 18, 2004 and May 30, 2005, the MII issued to Sohu Internet and Goodfeel, respectively, a Value-Added Telecommunications Services Operating License each of which authorized the provision of value-added telecommunication services nationwide. Both of these licenses have a valid term of five years and are subject to annual inspections. In addition to the Value-Added Telecommunications Services Operating License, we require various other licenses and permits so as to provide Internet-related services in China. For a detailed discussion, please refer below to “Classified Regulations”.
Our PRC Corporate Structure
We have the following subsidiaries in China:
•
Sohu Era, established in 2003 by Sohu Hong Kong;
•
Sohu Media, established in 2006 by Sohu Hong Kong;
•
Sohu Software, established in 2003 by Sohu Hong Kong;
•
Sogou Technology, established in 2006 by Sogou BVI;
•
Go2Map Software, acquired in 2005 as a result of the acquisition of Go2Map Inc; and
•
AmazGame Age, established in 2007 by TL Age Hong Kong.
Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age are structured as wholly foreign-owned companies engaged in the development of Internet technologies, online game and related software. Under current PRC laws, the establishment of wholly foreign-owned companies must be approved by the relevant local branch of the MOC, and such companies may commence operations only upon the issuance of a business license by the relevant local branch of the State AIC, such as the Beijing AIC. Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age have been issued business licenses by Beijing AIC, and Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age have obtained a New Technology Enterprise Qualification Certificate issued by Beijing Science and Technology Commission.
In the opinion of TransAsia Lawyers, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age have presently satisfied both of the aforementioned requirements.
As mentioned above, the telecommunications value-added services business is an area in which foreign investment is restricted. Thus, we have established the following VIEs through contractual arrangements with our subsidiaries to perform certain value-added telecommunications services.
•
High Century, a PRC company established in 2001, and 80% owned by Dr. Zhang, our founder, Chairman and Chief Executive Officer, and 20% owned by one of our employees. High Century is structured as an investment management and consulting company in China;
•
Sohu Entertainment, formerly known as Beijing Hengda Yitong Internet Technology Development Co., Ltd, or Hengda, a PRC company established in 2002, that is owned by two of our employees. Hengda is structured to provide Internet-related services in China. The company’s name of Hengda was changed to Sohu Entertainment as of June 9, 2006;
•
Sohu Internet, a PRC company established in 2003, that is 75% owned by High Century and 25% owned by Sohu Entertainment. Sohu Internet is structured to provide Internet-related services in China;
•
Goodfeel, a PRC company we acquired in 2004. Goodfeel is owned by two of our employees and has entered into a series of agreements to provide wireless services in China;
•
Huohu, a PRC company established in 2005. Huohu is owned by Sohu Era and an employee of Sohu. Huohu is structured to engage in software and technology development for the game business;
•
Tu Xing Tian Xia, a PRC company we acquired in 2005. High Century and Sohu Internet own 56.1% and 43.9% interests in Tu Xing Tian Xia, respectively. Tu Xing Tian Xia is structured to provide online mapping service in China;
•
Feng Yang Tian Lang, a PRC company that we established in December 2005. High Century and Sohu Internet each holds 50% of the equity interests in Feng Yang Tian Lang, which is structured to engage in the online advertising business;
•
Sogou Information, a PRC company that we established in December 2005. Sogou Information is owned by two of our employees and is structured to provide Internet-related services in China;
•
21 East Beijing, a PRC company engaging in entertainment business in China. We acquired 70% interests in 21 East Beijing through High Century in October 2006. The remaining 30% interests in 21 East Beijing was owned by one of our employees;
•
Gamease Age, a PRC company that we established in September 2007. Gamease Age is owned by two of our employees and is structured to provide online game services in China; and
•
New 21 East, a PRC company that we established in December 2007 and engaging in entertainment business in China. New 21 East is 70% owned by High Century and 30% owned by one of our employees.
Sohu has extended interest-free loans to the individual shareholders of the VIEs to fund their capital investment in the VIEs. We have also entered into a series of agreements with the individual shareholders to transfer their shares in the VIEs to us when required to do so. All of our VIEs presently have valid business licenses issued by the relevant local branch of the State AIC. In addition, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Sogou Information and Gamease Age have been issued New Technology Enterprise Qualification Certificates by Beijing Science and Technology Commission.
In February 2007, we completed the liquidation of one of our former VIEs, Beijing Sohu Online Network Information Services, Ltd. (or Beijing Sohu), a PRC company that was 80% owned by Dr. Zhang, our founder, Chairman and Chief Executive Officer, and 20% owned by High Century.
In July 2007, we completed the liquidation of one of our former subsidiaries, Beijing ITC, a wholly foreign-owned company established by Sohu Hong Kong.
In January 2008, we completed the liquidation of one of our former VIEs, Guangzhou Sohu Interactive Network Technology Co., Ltd. (Guangzhou Interactive), a PRC company that was 50% owned by Sohu Internet and 50% owned by High Century.
The MII promulgated on July 13, 2006 a Notice of the Ministry of Information Industry on Intensifying the Administration of Foreign Investment in Value-added Telecommunications Services. The notice is designed to strengthen the administration of foreign investment in PRC telecommunication businesses, particularly those involving value-added telecommunications services, which encompass a wide variety of activities related to the provision of service/content via telecommunications networks. As such, the notice requires the following: Telecom companies (or their shareholders) must hold the domain names and trademarks that they use in their provision of value-added telecommunication services, and must hold necessary business premises and facilities (including servers) within the region covered by their ICP licenses and correspond to the ICP services.
In compliance with the Notice of the Ministry of Information Industry on Intensifying the Administration of Foreign Investment in Value-added Telecommunications Services, an enterprise holding an ICP license must be the entity that possesses the key intellectual property rights, e.g., domain names and trademarks. In this connection, Sohu Era is in the process of transferring several of its domain names and trademarks to Sohu Internet, which will license the same to Sohu Era and Sohu Media.
In the opinion of TransAsia Lawyers, the ownership structures of each of Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software, AmazGame Age, High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information, 21 East Beijing, Gamease Age and New 21 East comply with all existing laws, rules and regulations of the PRC and each of the seventeen companies as described herein has the full legal right, power and authority, and has been duly approved to carry on and engage in the business as described in its business license.
Classified Regulations
Online Advertising
Under the Administrative Regulations for Advertising Licenses and the Implementation Rules for the Administrative Regulations for Advertising, both of which were issued by the State AIC on November 30, 2004 and effective as of January 1, 2005, enterprises (except for broadcast stations, television stations, newspapers and magazines, non-corporate entities and other entities specified in laws or administrative regulations) are generally exempted from the previous requirement to obtain an advertising license. Exempted enterprises are only required to apply for the inclusion of advertising services in their business license.
We established Feng Yang Tian Lang and Sohu Media in 2005 and 2006, respectively. Both companies included the provision of advertising services in their business scope on their business licenses.
Internet Information Services
On September 25, 2000, the State Council approved the Measures for the Administration of Internet Information Services, or the ICP Measures. Under the ICP Measures, any entity that provides information to online users of the Internet is obliged to obtain an operating license from the MII or its local branch at the provincial or municipal level in accordance with the Telecom Regulations described above.
The ICP Measures stipulate further that entities providing online information services regarding news, publishing, education, medicine, health, pharmaceuticals and medical equipment must procure the consent of the national authorities responsible for such areas prior to applying for an operating license from the MII or its local branch at the provincial or municipal level. Moreover, ICPs must display their operating license numbers in conspicuous locations on their home pages. ICPs are required to police their Websites and remove certain prohibited content. This obligation reiterates Internet content restrictions that have been promulgated by other PRC ministries.
Most importantly for foreign investors, the ICP Measures stipulate that ICPs must obtain the prior consent of the MII prior to establishing an equity or cooperative joint venture with a foreign partner.
On July 28, 2003, the BTA issued to Sohu Internet a Telecommunications and Information Services Operating License (or ICP license). On June 10, 2004, Goodfeel obtained an ICP license issued by BTA. On April 21, 2005, Tu Xing Tian Xia was issued an ICP license by BTA. On December 3, 2005, the BTA issued to Sogou Information an ICP license. On September 14, 2007, the BTA issued to Gamease Age an ICP license. All of these ICP licenses have a term of five years and are subject to annual inspections.
Online News Dissemination
On September 25, 2005, the Administrative Regulations for Internet News Information Services (or News Regulations) were jointly promulgated by the State Council Information Office and MII to replace the previous Provisional Rules for the Administration of the Operation of News Publication Services by Web Sites (or Old News Rules) issued on November 7, 2000. The News Regulations stipulate that general Websites established by non-news organizations, such as Sohu, may publish news released by certain official news agencies if such Websites satisfy the requirements set forth in Article 8 of the regulations but may not publish news items produced by themselves or other news sources. The aforementioned requirements include the following:
•
they must comply with the constitution, laws and regulations of the PRC, uphold and not mislead the society’s public opinion, and safeguard national and public interests;
•
they must have sound administrative rules and regulations concerning Internet news services;
•
they must have the necessary premises, equipment and legally-raised funds;
•
they must have ten or more professional news editors, at least five of whom have worked at a news agency for a minimum of three years;
•
they must be legal persons who have been legally established for at least two years, engaged in the operation of Internet news services and have not had administrative penalties imposed due to violation of laws and regulations on the administration of Internet news services within the last two years;
•
if the applicant is an enterprise legal person, its registered capital must not be less than Renminbi (or RMB) 10,000,000; and
•
they must only republish or disseminate news published by State news agencies or news agencies directly subordinate to the respective governments of the provinces, autonomous regions or directly-administered municipalities without distorting the original news information regarding current events and political affairs to the public, and indicate the source of such news information; and shall not publish news gathered and edited by themselves.
The aforementioned rules also require the general Websites of non-news organizations to apply to the SCIO at the national level for approval after securing the consent of the SCIO at the provincial level before they commence providing news dissemination services. Also, general Websites intending to publish news released by the aforementioned news agencies or bureaus must enter into agreements with them and submit copies of those agreements to the relevant administration department.
On May 11, 2004, Sohu Internet obtained a permit to engage in online news dissemination services, which was issued by the Information Office of the Beijing Municipal Government (the local arm of the SCIO) under the Old News Rules. On June 6, 2006, such permit was updated by the SCIO in accordance with the News Regulations.
Internet Medical, Health and Pharmaceuticals Information Services
The Measures for the Administration of Internet Medical and Health Information Services were issued by the Ministry of Health, or MOH, on January 8, 2001. Under these measures, the MOH is responsible for reviewing the qualifications of Websites and approving their publication of health-related information. Additionally, in accordance with the Provisional Rules for the Administration of Internet Pharmaceuticals Information Services, issued by the State Food and Drug Administration, or SFDA, on July 8, 2004, the formal approval of the SFDA or one of its local branches is required before a Website may disseminate information concerning pharmaceuticals.
According to the aforementioned regulations, medical, health and pharmaceutical information provided by Websites must be scientific and accurate and must indicate the sources of such information. Websites that are approved to disseminate such information must also publish or reprint health policies, information on epidemics and major health-related incidents, and other health-related information in accordance with law. Furthermore, medical and pharmaceutical advertisements published by such Websites must not exaggerate the efficacy or promote the medical uses of such products.
Sohu Internet obtained the aforementioned approvals from and completed registration with the MOH on November 17, 2005. On October 25, 2004, Sohu Internet received from the SFDA approval to disseminate information concerning pharmaceuticals.
Online Audiovisual Transmission
On July 6, 2004, the SARFT issued the Measures for the Administration of the Transmission of Audiovisual Programs over Information Networks such as the Internet, which came into effect on October 11, 2004. These measures provide that Websites authorized to disseminate news may apply to the SARFT to obtain a Permit for the Network Transmission of Audiovisual Programs allowing the online dissemination of streaming video. In accordance with these measures, we applied to the SARFT for this permit in 2005, but have not yet obtained said Permit.
In December 20 2007, the SARFT and the MII jointly issued the Rules for the Administration of Internet Audiovisual Program Services (Document 56), which came into effect as of January 31, 2008. The rules require all online audio and video service providers to be either state-owned or state-controlled. They also encourage state-owned entities to actively invest in online audiovisual services. However, further to this, in a press conference on February 3, 2008, the SARFT and the MII clarified that online audio-visual service providers that were already lawfully operating prior to the issuance of Document 56 may re-register and continue to operate without becoming state-owned or controlled, provided that such providers do not engage in any unlawful activities. This exemption will not be granted to service providers set up after Document 56 was issued. As we were already engaged in online audiovisual transmission prior to the issuance of Document 56, we are presumably exempted from the requirement of being state-owned or state-controlled. We will re-register with SARFT to continue to operate our online audiovisual transmission business.
Internet Publishing
The Rules for the Administration of the Publications Market, issued by the GAPP on July 16, 2003, define the online distribution of publications as the offering of online subscriptions for, and the purchase, storage, shipment, and sale of, publications over the Internet. On June 27, 2002, the GAPP and MII jointly issued the Provisional Rules for the Administration of Internet Publishing, or Internet Publishing Rules, which define “Internet publications” as works that are either selected or edited to be published on the Internet or transmitted to end-users through the Internet for the purposes of browsing, reading, using or downloading by the general public. Such works primarily include content or articles formally published publicly in other press such as: (a) books, newspapers, periodicals, audio-visual products and electronic publications and (b) literature, art and articles on natural science, social science, engineering and other topics that have been edited. Under the Internet Publishing Rules, Web portals such as ours are required to apply to and register with the GAPP before distributing Internet publications.
In this regard, Sohu Internet obtained approval from the Beijing News and Publications Bureau (the local arm of the GAPP) on January 26, 2004, to distribute Internet publications.
Online Games and Cultural Products
On December 30, 1997, the SPPA (renamed as the GAPP) issued the Rules for the Administration of Electronic Publications, or Electronic Publication Rules, which took effect as of January 1, 1998. The Electronic Publication Rules outline a licensing system for business operations involving electronic publications, which are currently interpreted by the GAPP to include online games. Under the Electronic Publication Rules, if a PRC company is contractually authorized to publish foreign electronic publications, it must obtain the approval of, and register the copyright license contract with GAPP. On July 27, 2004, the GAPP issued a Notice for the Implementation of the State Council Decision for Centralization of the Approval Power of the Electronic, which required that foreign games be imported through the holder of Permit for Internet Publishing. At the end of 2006, the GAPP further required the holder of the Permit for the Internet Publishing to submit a monthly report stating that any foreign online game which it publishes has not had significant changes in content since the approval.
On May 10, 2003, the MOC issued the Provisional Regulations for the Administration of Online Culture, which took effect on July 1, 2003. This regulation applies to entities engaging in activities related to “online cultural products”, including music and video files, network games, animation features and audiovisual products, performed plays and artwork converted for dissemination via the Internet. Pursuant to this legislation, commercial entities are required to apply to the relevant local branch of the MOC for an Online Culture Operating Permit if they engage in any of the following types of activities:
•
the production, duplication, importation, wholesale, retail, leasing or broadcasting of online cultural products;
•
the dissemination of online cultural products on the Internet or transmission thereof to computers, fixed-line or mobile phones, radios, television sets or gaming consoles for the purpose of browsing, reading, using or downloading such products; or
•
the exhibition or holding of contests related to online cultural products.
On May 14, 2004, the MOC issued the Notice Regarding the Strengthening of Network Game Censorship. This notice mandates the establishment of a new committee under the MOC that will screen imported online games for politically sensitive content. The committee will censor games that “threaten state security”, “disturb the social order”, “distort historical facts” or infringe on third party intellectual property rights.
On July 12, 2005, the MOC and the MII promulgated the Opinions on the Development and Administration of Online Gaming, reflecting the Chinese government’s intent to foster and control the development of the online gaming industry in China.
In September 2003 and December 2007, the MOC issued an Online Culture Operating Permit to Sohu Internet and Gamease Age, respectively, authorizing us to provide online game services. This permit is subject to annual inspection.
Online Audiovisual Products Distribution
On November 25, 2006, the newly amended Measures for the Administration of the Wholesale Retail and Rental of Audiovisual Products were promulgated by the Ministry of Culture as Decree No.40 and were effective as of December 1, 2006; the original Measures for the Administration of the Wholesale, Retail and Rental of Audiovisual Products were repealed. The new measures substantially amend the old measures by lowering the requirements related to market access, business premises size and number of full-time staff, by canceling restrictions on the registered capital of entities distributing audiovisual products, and by encouraging diversity in business models. On August 10, 2004, the Beijing Cultural Bureau (the local arm of the MOC) issued to Sohu Internet an Audiovisual Products Operating Permit authorizing the online distribution of audiovisual products.
In addition, the 2003-2010 Development Plan for the Cultural Market, issued on February 20, 2003 by the MOC, outlines the MOC’s plans to initiate an electronic administration system for the distribution of audiovisual products online. Although no specific legislation has been issued in this regard, we are aware that further administrative approvals may be required in the future in connection with our online audiovisual product business activities.
International Connections for Computer Information Networks
The State Council and the MII have promulgated regulations governing international connections for PRC computer networks, including:
•
Measures for the Administration of International Connections to China’s Public Computer Interconnected Networks (1996);
•
Provisional Regulations of the People’s Republic of China for the Administration of International Connections to Computer Information Networks (1997) and their Implementing Measures (1998);
•
Reply Concerning the Verification and Issuance of Operating Permits for Business Relating to International Connections for Computer Information Networks and for Public Multimedia Telecommunications Business (1998); and
•
Administrative Measures for International Communications Gateways (2002).
Under the above regulations, any entity wishing to access international connections for their computer information networks in the PRC must comply with the following requirements:
•
be a PRC legal person;
•
have the appropriate equipment, facilities and technical and administrative personnel;
•
have implemented and registered a system of information security and censorship; and
•
effect all international connections through an international communications gateway established with the approval of the MII.
We adopted the relevant measures to ensure that we are in proper compliance with all of these requirements.
Information Security and Censorship
The principal pieces of PRC legislation concerning information security and censorship are:
•
The Law of the People’s Republic of China on the Preservation of State Secrets (1988) and its Implementing Rules (1990);
•
The Law of the People’s Republic of China Regarding State Security (1993) and its Implementing Rules (1994);
•
Rules of the People’s Republic of China for Protecting the Security of Computer Information Systems (1994);
•
Notice Concerning Work Relating to the Filing of Computer Information Systems with International Connections (1996);
•
Administrative Regulations for the Protection of Secrecy on Computer Information Systems Connected to International Networks (1999);
•
Regulations for the Protection of State Secrets for Computer Information Systems on the Internet (2000);
•
Notice issued by the Ministry of Public Security of the People’s Republic of China Regarding Issues Relating to the Implementation of the Administrative Measure for the Security Protection of International Connections to Computer Information Networks (2000);
•
The Decision of the Standing Committee of the National People’s Congress Regarding the Safeguarding of Internet Security (2000); and
•
Measures for the Administration of Commercial Website Filings for the Record (2002) and their Implementing Rules (2002).
These pieces of legislation specifically prohibit the use of Internet infrastructure where it results in a breach of public security, the provision of socially destabilizing content or the divulgence of State secrets, as follows:
•
“A breach of public security” includes breach of national security or disclosure of state secrets; infringement on state, social or collective interests or the legal rights and interests of citizens or illegal or criminal activities.
•
“Socially destabilizing content” includes any action that incites defiance or violation of Chinese laws; incites subversion of state power and the overturning of the socialist system; fabricates or distorts the truth, spreads rumors or disrupts social order; advocates cult activities; or spreads feudal superstition, involves obscenities, pornography, gambling, violence, murder, or horrific acts or instigates criminal acts.
•
“State secrets” are defined as “matters that affect the security and interest of the state”. The term covers such broad areas as national defense, diplomatic affairs, policy decisions on state affairs, national economic and social development, political parties and “other State secrets that the State Secrecy Bureau has determined should be safeguarded.”
According to the aforementioned legislation, it is mandatory for Internet companies in the PRC to complete security filing procedures with the local public security bureau and for them to update regularly with the local public security bureau regarding information security and censorship systems for their Websites. In this regard, the Detailed Implementing Rules for the Measures for the Administration of Commercial Website Filings for the Record, promulgated in September 1, 2000 by the Beijing AIC, state that Websites must comply with the following requirements:
•
they must file with the Beijing AIC and obtain electronic registration marks;
•
they must place the registration marks on their Websites’ homepages; and
•
they must register their Website names with the Beijing AIC.
Sohu Internet successfully registered its Website with the Beijing AIC on September 11, 2003. Accordingly, the electronic registration mark is prominently placed on its homepage.
In addition, the State Security Bureau has issued regulations authorizing the blocking of access to any site it deems to be leaking State secrets or failing to meet the relevant legal legislation regarding the protection of State secrets in the distribution of information online. Specifically, Internet companies in China with message boards, chat rooms or similar services, such as Sohu, must apply for the approval of the State Secrets Bureau prior to operating such services.
Accordingly, we have established an internal security committee and adopted security maintenance measures, employed a full-time supervisor and exchanged information on a regular basis with the local public security bureau with regard to sensitive or censored information and Websites.
Encryption Software
In October 1999, the State Encryption Administration Commission promulgated the Regulations for the Administration of Commercial Encryption, followed in November 1999 by the Notice of the General Office of the State Encryption Administration Commission. Both of these regulations address the use in China of software with encryption functions.
According to these regulations, encryption products purchased for use must be reported. Violation of the encryption regulations may result in the issuance of a warning, levying of a penalty, confiscation of the encryption products and even criminal liabilities. On March 18, 2000, the Office of the State Commission for the Administration of Cryptography issued a public announcement regarding the implementation of those regulations. The announcement clarifies that:
•
Only specialized hardware and software, the core functions of which are encryption and decoding, fall within the administrative scope of the regulations as “encryption products and equipment containing encryption technology.” Other products such as wireless telephone, Windows software and browsers do not fall within this scope.
•
The State Commission for the Administration of Cryptography changed its name to the State Cryptography Administration Bureau (SCAB) in March 2005. The SCAB maintains authority over the importation, research, production, sale and use of cryptographic products in China (“products” are defined to include any cryptographic technologies and products to be applied in the encryption or secure authentication of information other than state secrets). Legislation was issued to restrict the importation, research, production and sale of encryption products and requiring that the encryption functions of such products be placed in escrow with the SCAB for reasons of national security.
We are in full compliance with current PRC legislation governing encryption software.
Wireless Services
Sohu Internet and Goodfeel’s business activities include the provision of online services related to wireless services, including SMS, RBT, WAP, MMS and IVR.
On April 25, 2004, the MII issued a notice stating that mobile network operators can only provide mobile network access to those mobile Internet service providers which have obtained licenses from the relevant local arm of the MII before conducting operations, and that such carriers must terminate mobile network access for those providers who have not secured the required licenses within a thirty-day grace period. On the basis of the notice, China Mobile Communication Corporation, or CMCC, has required each of its mobile Internet service providers to first obtain a license for trans-regional value-added telecommunications services in order to gain full access to its mobile network, which is a nationwide policy in line with a similar notice issued by the Beijing branch of CMCC on April 12, 2004.
Sohu Internet and Goodfeel were granted the license to provide trans-regional value-added telecommunication services on August 18, 2004 and March 30, 2005, respectively.
Consumer Protection and E-mail Services
The MII has set forth various requirements for consumer protection in a notice issued on April 15, 2004, which addresses certain problems in the telecommunications sector, including ambiguity in billing practices for premium services, poor quality of connections and unsolicited SMS messages, all of which infringe upon the rights of consumers.
This trend was continued with the issuance of the Notice Regarding the Ratification and Administration of Mobile Information Services Fees and Charges Method by MII on May 23, 2006.
In addition, there has been a movement in China toward industry self-regulation to combat the problem of unsolicited e-mails. Specifically, on March 25, 2003, the China Internet Association issued the Anti-Spam E-Mail Guidelines. These guidelines set forth a number of mechanisms that Internet service providers in China may adopt to cut down the use of their systems to send unsolicited e-mail. We have adopted these guidelines in our operations.
On February 20, 2006, the MII promulgated the Measures for the Administration of Internet E-mails Services, effective as of March 30, 2006. Under these new regulations, the “Opt-in” System is expected to be introduced into the area of e-mail services, whereby e-mails containing commercial advertisements are not delivered unless specifically requested by users. Furthermore, the subject line of all e-mails containing commercial advertisements will be required to have the label of “advertisement” or “AD”. In addition, the IP address of each server that supports e-mail will be registered in order to facilitate the tracing and identification of spam sources. We have adjusted our e-mail systems and forms to fulfill the relevant requirements.
We are aware of the increasingly strict legal environment covering consumer protection in China, and we attempt to adopt all necessary measures to ensure that our business complies with these evolving standards.
Employment Contract
On June 29, 2007, the National People’s Congress promulgated the Employment Contract Law of PRC (Employment Contract Law), which became effective as of January 1, 2008. The Employment Contract Law requires employers to provide written contracts to their employees, restricts the use of temporary workers and aims to give employees long-term job security.
Pursuant to the Employment Contract Law, employment contracts lawfully concluded prior to the implementation of the Employment Contract Law and continuing as of the date of its implementation shall continue to be performed. Where an employment relationship was established prior to the implementation of the Employment Contract Law but no written employment contract was concluded, a contract must be concluded within one month after its implementation.
We have modified our standard employment contract to comply with the requirements of the Employment Contract Law. In addition, we are in the process of signing written employment contracts with all of our employees who had not signed employment contracts with us prior to the effective date of the Employment Contract Law.
Conclusion
In the opinion of TransAsia Lawyers, our companies are approved to engage in the specific online services (categorized and addressed in the above sections) as described in the respective scopes indicated in the corresponding licenses and/or permits issued to the respective companies.
Intellectual Property and Proprietary Rights
We regard our copyrights, service marks, trademarks, trade secrets and other intellectual property as critical to our success. We rely on trademark and copyright law, trade secret protection, non-competition and confidentiality and/or license agreements with our employees, customers, partners and others to protect our intellectual property rights. Despite our precautions, it may be possible for third parties to obtain and use our intellectual property without authorization. Furthermore, the validity, enforceability and scope of protection of intellectual property rights in Internet-related industries are uncertain and still evolving. The laws of the PRC and certain other countries do not protect intellectual property to the same extent as do the laws of the United States.
We have registered three service marks with the U.S. Patent and Trademark Office. They are (i) Sohu.com, registered on August 1, 2000; (ii) Sohu.com (stylized), registered on August 1, 2000; and (iii) Sohu, registered on June 13, 2000. We received the registration certificate for the mark “Sohu.com” issued by the China Trademark Office in October 2000. We have also filed registration applications with the China Trademark Office to register other key marks, including the Sohu Fox logo, 17173.com, Focus.cn, Goodfeel, Sogou, Go2Map and their corresponding Chinese version marks. We received registration certificate for the marks “Focus.cn” and “Go2Map”, respectively, in November 2004 and November 2000, and transfer certificates for the marks “17173” and “GoodFeel”, respectively, in February 2005 and June 2006, while the others are still under examination by the China Trademark Office. Our rights to these marks could be affected adversely if any of our applications are rejected. In addition, it is possible that our competitors will adopt product or service names similar to ours, thereby impeding our ability to distinguish our brand and possibly leading to customer confusion.
Many parties are actively developing chat, homepage, search and related Web technologies. We expect these parties to continue to take steps to protect these technologies, including seeking patent protection. There may be patents issued or pending that are held by others and cover significant parts of our technology, business methods or services. For example, we are aware that a number of patents have been issued in the areas of e-commerce, Web-based information indexing and retrieval and online direct marketing. Disputes over rights to these technologies may arise in the future. We cannot be certain that our products do not or will not infringe valid patents, copyrights or other intellectual property rights held by third parties. We may be subject to legal proceedings and claims, from time to time, relating to the intellectual property of others in the ordinary course of our business.
We also intend to continue licensing technology from third parties. The market is evolving and we may need to license additional technologies to remain competitive. We may not be able to license these technologies on commercially reasonable terms or at all. In addition, we may fail to successfully integrate any licensed technology into our services. Our inability to obtain any of these licenses could delay product and service development until alternative technologies can be identified, licensed and integrated.
Technology Infrastructure
Currently, we have established four main service provision centers in Beijing through China Netcom Communication Corporation, or CNC, China Telecom Corporation, or China Telecom, and China Education and Research Network, or CERNET, to maintain most of
our servers. CNC, China Telecom, and CERNET are the three largest Internet connection service providers in China and their nodes in Beijing are one of their core nodes across China. In addition, we have established 8 branch nodes in different provinces in China through CNC, China Telecom, CERNET, China Mobile and Unicom Corporation Limited (or Unicom), in order to establish national coverage and provide fast and stable access to our Website properties to users across China.
We have developed a close working relationship with CNC and its Beijing Subsidiary, China Telecom and CERNET. Our operations depend on the ability of CNC’s Beijing Subsidiary, China Telecom and CERNET to protect their systems against damage from fire, power loss, telecommunications failure, break-ins and other events. CNC’s Beijing Subsidiary, China Telecom and CERNET provide us with support services twenty-four hours per day, seven days per week. CNC’s Beijing Subsidiary, China Telecom and CERNET also provide connectivity for our servers through multiple high-speed connections. All facilities are protected by multiple power supplies.
For reliability, availability, and serviceability, we have created an environment in which each server can function separately. Key components of our server architecture are served by multiple redundant machines. We also use in-house and third-party monitoring software. Our reporting and tracking systems generate daily traffic, demographic and advertising reports. We deploy load balance equipment to avoid single point failure.
Our portal must accommodate a high volume of traffic and deliver frequently updated information. Components or features of our portal have in the past suffered outages or experienced slower response times because of equipment or software down time. These events have not had a material adverse effect on our business to date, but such events could have a material adverse effect in the future.
Employees
As of December 31, 2007, we had 2,373 full-time and part-time employees. We also employ independent contractors to support our research and development, sales, marketing, and editorial departments. None of our personnel are represented under collective bargaining agreements.
Our senior management, key executives and most full-time employees have entered into confidentiality, non-competition and non-solicitation agreements with us. In addition, most of our employees have employment agreements with Sohu Era, Sohu Media, Sogou Technology, AmazGame Age, Sohu Internet, Goodfeel, Feng Yang Tian Lang, Sogou Information and Gamease Age, our PRC operating entities, which contain similar confidentiality and non-competition undertakings. However, the degree of protection afforded to an employer pursuant to confidentiality and non-competition undertakings governed by PRC law may be more limited when compared to the degree of protection afforded under the laws of other jurisdictions. A significant number of our employees hold share-based awards in Sohu, which provides additional financial incentives to them. These awards generally vest over a period of one to four years.
Available Information
Our corporate Website is located at http://corp.sohu.com. We make available free of charge on or through our corporate Website our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission, or SEC. You will find links to copies of these reports, and to copies of Section 16 filings related to Sohu, by clicking on “Investor Relations” on the first full English page. Information contained on our corporate Website is not part of this report or any other report filed with the SEC.
ITEM 1A
ITEM 1A RISK FACTORS
Risks Related to Our Business
We are a relatively young company subject to the risks associated with operating in a new and evolving market.
As a relatively young company in the new and rapidly evolving PRC Internet market, we face numerous risks and uncertainties. Some of these risks relate to our ability to:
•
continue to attract a larger audience to our matrices of Web properties and proprietary search engines by expanding the type and technical sophistication of the content and services we offer;
•
maintain our current, and develop new, strategic relationships to increase our revenue streams as well as product and service offerings;
•
increase the revenues derived from our fee-based services and products we offer online;
•
build our sponsored search, online game, and wireless businesses successfully; and
•
attract and retain qualified personnel.
Our operating results are likely to fluctuate significantly and may differ from market expectations.
Our annual and quarterly operating results have varied significantly in the past, and may vary significantly in the future, due to a number of factors which could have an adverse impact on our business, such as our reliance on advertisers in certain industries for brand advertising revenues, our reliance on certain key third party distributors for sponsored search revenues, our reliance on operation of TLBB for online games revenues and our reliance on mobile network operators for our wireless revenues. The Chinese Internet industry is at an early stage of development. We are unsure if it will continue to grow, and if it does, the rate at which it will grow. In addition, we are subject to government regulations that may change at any time with or without notice. Fluctuations in the industries of our key advertisers may affect our brand advertising revenues materially, because they may cut their spending on online marketing if there is any downturn in their industries. We rely on certain third party distributors to sell our sponsored search products. If we lose any of our key distributors, our business may be materially affected. We rely on our operation of TLBB to derive most of our online game revenue. If there were any interruptions of TLBB’s operation, our online games revenue could be adversely affected. We rely on mobile network operators for, among other things, billing of and collection of wireless service fees from mobile phone users. If our arrangements with the operators were to be terminated, altered or not renewed, or if the operators did not provide continuous or adequate service, our wireless revenues could be reduced significantly.
As a result, we believe that year-to-year and quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. In addition, we have experienced very high growth rates in certain business lines in the past, and there may be expectations that these growth rates will continue. In the past, our operating results have sometimes fallen below the expectations of public market analysts and investors, and they may do so again in the future. In this event, the trading price of our common stock may fall.
We face intense competition which could reduce our market share and adversely affect our financial performance.
There are many companies that distribute online content and services targeting Chinese users. We compete with distributors of content and services over the Internet, including Web directories, search engines, content sites, Internet service providers and sites maintained by government and educational institutions. These sites compete with us for visitor traffic, advertising dollars, online game users, potential partners and wireless services. The Internet market in China is relatively new and rapidly evolving. Competition is intense and expected to increase significantly in the future, because there are no substantial barriers to entry in our market.
We have many competitors in the PRC Internet market, including Sina, Tencent, Netease, PConline, SouFun, Baidu, Google, Yahoo! China, SoSo, Shanda, The9, Perfect World, Giant Interactive, Netdragon, Kingsoft, Tom Online, KongZhong, Linktone and Hurray!. In addition, there are a number of existing or new PRC Internet portals, including those controlled or sponsored by PRC government entities. These private and government sponsored competitors may have certain competitive advantages over us in terms of:
•
substantially greater financial and technical resources;
•
more extensive and well developed marketing and sales networks;
•
better access to original content and information;
•
greater global brand recognition among consumers; and
•
larger customer bases.
We compete with other portals in China primarily on the following bases:
•
technological advancements;
•
attractiveness of products;
•
brand recognition;
•
volume of traffic and users;
•
quality of our Websites and content;
•
strategic relationships;
•
quality of our services;
•
effectiveness of sales and marketing efforts;
•
talented staff; and
•
price.
Our existing competitors may in the future achieve greater market acceptance and gain a greater market share through launching of new products, introducing new technologies, or forming alliances among themselves in order to enhance their ability to compete with us. It is also possible that new competitors may emerge and acquire significant market share. In particular, our search engine faces intense competition from software and other Internet products and services incorporating search and retrieval capabilities, such as Baidu, Google, Yahoo! China and SoSo. In addition, operators of leading Websites or Internet service providers, including Yahoo!, Microsoft/MSN and AOL, currently offer, and could expand, their online products and services targeting China. Such entities may cooperate with other organizations, such as telecommunication operators, in China to accelerate their entry into, and to enhance their competitiveness in, the Chinese market. For example, on September 19, 2006, China Telecom and Microsoft announced an agreement pursuant to which Microsoft will provide Windows Live search service to 25 million users of China Telecom. We believe the rapid increase in China’s online population will draw more attention from these multinational players to the PRC Internet market. We also compete with traditional forms of media, such as newspapers, magazines, radio and television, for advertisers and advertising revenues.
If we fail to successfully develop and introduce new products and services, our competitive position and ability to generate revenues could be harmed.
We are continuously developing new products and services for our users. The planned timing or introduction of new products and services is subject to risks and uncertainties. Actual timing may differ materially from original plans. Unexpected technical, operational, distribution or other problems could delay or prevent the introduction of one or more of our new products or services. Moreover, we cannot be sure that any of our new products and services will achieve widespread market acceptance or generate incremental revenue.
Our business depends on a strong brand, thus we will not be able to attract users, customers and clients of our products and offerings if we do not maintain and develop our brands.
It is critical for us to maintain and develop our brands so as to effectively expand our user base and our revenues. We believe that the importance of brand recognition will increase as the number of Internet users in China grows. In order to attract and retain Internet users, advertisers, online games and wireless customers, we may need to substantially increase our expenditures for creating and maintaining brand loyalty. Accordingly, our revenues will need to increase at least proportionately in order for us to maintain our current levels of profitability.
Our success in promoting and enhancing our brands, as well as our ability to remain competitive, will also depend on our success in offering high quality content, features and functionality. If we fail to promote our brands successfully or if visitors to our Websites or advertisers do not perceive our content and services to be of high quality, we may not be able to continue growing our business and attracting visitors, advertisers, wireless, and online game customers.
Our failure to keep up with rapid technology changes may severely affect our future success.
The Internet industry is undergoing rapid technological changes. Our future success will depend on our ability to respond to rapidly evolving technologies, adapt our services to changing industry standards and improve the performance and reliability of our services. If we fail to adapt to such changes, our business may be adversely affected. For example, with the evolution of Web 2.0, Internet users may shift to new modes of information sharing, such as blogs. Moreover, we have used peer-to-peer streaming technology on video content to promote our online video. Our competitors may develop their own peer-to-peer streaming technology or update their existing technology to surpass us. With the development of search engine technologies, Internet users may choose to access information, news and content through search engines rather than portals. In addition, the online games industry is evolving rapidly, so we need to anticipate new technologies and games and evaluate their possible market acceptance. We may be unable to recover our game development costs if our new online games are less attractive to users. In addition, with the development of 2.5G and even 3G technology, the focus of wireless applications has been transferred from text message services to multi-media message services, wireless games, wireless downloads and other applications. Accordingly, we will need to adapt our business to cope with the changes and support these new services to be successful. In addition, the MII is cooperating with other administrations, including the Ministry of Public Security, the Ministry of Culture and the Ministry of Justice, to draft industry standards or regulations regarding Spyware software. If we cannot adapt to new industry standards, more technical expenses could be required in the future.
We depend on online advertising for a significant portion of our revenues, but the online advertisement market includes many uncertainties, which could cause our advertising revenues to decline.
We derive a significant portion of our revenues, and expect to derive a significant portion of our revenues for the foreseeable future, from the sale of advertising on our Websites. Advertising revenues represented approximately 63% and 68% of our total revenues for the years ended December 31, 2007 and 2006, respectively. For the years ended December 31, 2007 and 2006, our five largest advertisers accounted for approximately both 14% of our total brand advertising revenues. The growth of our advertising revenues relies on increased revenue from the sale of advertising spaces on our Websites, which may be affected by many of the following risk factors:
•
The online advertising market is new and rapidly evolving, particularly in China. As a result, many of our current and potential advertising clients have limited experience using the Internet for advertising purposes and historically have not devoted a significant portion of their advertising budget to Internet-based advertising.
•
Changes in government policy could restrict or curtail our online advertising services. For example, in 2006 and 2007, the PRC government has enacted a series of regulations, administrative instructions and policies to restrict online medical advertising. As a result of these regulations, we may lose some of our existing medical advertising clients.
•
Advertising clients that have invested substantial resources in other methods of conducting business may be reluctant to adopt a new strategy that may limit or compete with their existing efforts.
•
The acceptance of the Internet as a medium for advertising depends on the development of a measurement standard. No standards have been widely accepted for the measurement of the effectiveness of online advertising. Industry-wide standards may not develop sufficiently to support the Internet as an effective advertising medium. If these standards do not develop, advertisers may choose not to advertise on the Internet in general or through our portals or search engines.
In addition, our ability to generate and maintain significant online advertising revenues will also depend upon:
•
the development of a large base of users possessing demographic characteristics attractive to advertising clients;
•
the acceptance of online advertisement as an effective way for business marketing by advertising clients;
•
the effectiveness of our advertising delivery, tracking and reporting systems; and
•
the resistance pressure on online advertising prices and limitations on inventory.
We rely on advertising agencies to sell our brand advertising services. If current trends of consolidation of advertising agencies in the Chinese market continue, the bargaining power of the large advertising agencies resulting from such consolidation may permit them to require that we pay higher sales rebates, which would adversely affect our gross margin.
Most of our brand advertising services are distributed by advertising agencies. In 2007, for example, approximately 90% of our brand advertising revenues were derived from advertising agencies. In consideration for these agencies’ services, we are required to pay certain percentages of revenues as sales rebates. During 2007, the biggest 10 advertising agencies in China contributed more than 50% of our brand advertising revenue. These advertising agencies currently are seeking consolidation in the market. For example, Focus Media, one of the biggest advertising agencies, was reported to be acquiring other large advertising agencies in the Chinese market. If the online advertising market is consolidated and effectively controlled by a small number of large advertising agencies, such advertising agencies may be in a position to demand higher sales rebates based on increased bargaining power, which could negatively affect our brand advertising growth as we book our brand advertising revenue net of our sales rebates to advertising agencies.
The expansion of Internet advertisement blocking software may result in a decrease of advertising revenues.
The development of Web software that blocks Internet advertisements before they appear on a user’s screen may hinder the growth of online advertising. The expansion of advertisement blocking on the Internet may decrease our revenues because when an advertisement is blocked, it is not downloaded from our advertisement server. As a result, such advertisements will not be tracked as a delivered advertisement. In addition, advertisers may choose not to advertise on the Internet or on our Websites because of the use by third parties of Internet advertisement blocking software.
Our failure to retain key distributors or attract additional distributors for our sponsored search customers could have an adverse impact on our business.
Sponsored search is at an early stage of development in China and is not as widely accepted by or available to businesses in China as in the United States. As a result, we rely heavily on our nationwide distribution network of third-party distributors for our sales to, and collection of payment from, our sponsored search customers. If our distributors do not provide quality services to our customers or otherwise breach their contracts with them, we may lose our customers. We do not have long-term agreements with any of our distributors, including our key distributors, and cannot assure that we will continue to maintain favorable relationships with them.
We rely on our Website Alliance members for a significant portion of our sponsored search revenues. If we fail to retain existing Website Alliance members or attract additional members, our revenues and growth may be adversely affected.
By posting bid listing links on their Websites, we share the revenues generated from clicks by users with our Website Alliance members. For the year ended December 31, 2007, the total revenues generated from Website Alliance accounted for approximately 67% of our total bid listing revenues. We consider our Website Alliance critical to the future growth of our sponsored search revenues. If our Website Alliance members decide to use a competitor’s or their own Internet search services, or if we fail to attract additional Websites to join our Website Alliance, our sponsored search revenues may decline.
We rely on our online games for a significant portion of our revenues. If we fail to retain existing online game users or attract additional users, our revenues may be adversely affected.
As of December 31 2007, we operated two online games, namely TLBB and BO, which collectively represent approximately 22% of our total revenues for the year ended December 31, 2007. Our online game revenue depends on continuous consumption of our game services by game users. As of December 31, 2007, we had more than 23 million registered users for our games. We may lose our online game users if we cannot provide continuously satisfactory service. For example,
•
We may not detect programming errors, flaws or bugs before we launch new games, or new extension packs for existing games. In addition, we may not be able to solve the errors, flaws or bugs in a timely manner when reported by our users or detected by ourselves;
•
We may not respond and/or resolve complaints from our users timely;
•
We may experience uncertainties when operating the games, such as breakdowns of servers, interruptions of the network, and crashes of systems, which could cause temporary interruption of access for our game users to our game services;
•
We may fail to provide our users a secure game system. For example, hackers may invade our systems and steal our players’ account information and in-game virtual properties; and
•
We may fail to detect and prevent players from obtaining unfair in-game advantages by installing and using hacking or cheating tools to facilitate character enhancement.
Our failure to address the abovementioned issues could adversely affect the in-game experiences of users, damage the reputation of our games, shorten the lifecycle of our games, and eventually result in the loss of users and a reduction in our revenues.
Our online game business may not succeed in a highly competitive market
Competition in the online game market in China is becoming more and more intense. For example, according to 17173.com statistics, in the fourth quarter of 2007, 51 new MMORPG games or advanced casual games were launched. In the second half of 2007, there were four online game companies, Perfect World, Giant Interactive, Netdragon and Kingsoft, that successfully listed their shares on Nasdaq or the Hong Kong stock market. Prior to those listings, there were only three listed online game companies in China, Shanda, The9 and Netease. Moreover, venture capital funds are investing increasing amounts of capital into the market, which has resulted in even more heated competition. Recently, many of our competitors have become more aggressive in the hiring of talent for game development, increasing spending on games marketing and bidding for games licensing. Increased competition in the online game industry may make it difficult for us to retain and expand our existing user base, growth rate and profitability.
We depend on the introduction of new online games and improvements of our existing games to sustain our profitability. If we fail to develop and launch new online games or to improve our existing games, our profitability may be adversely affected.
Currently, we operate two online games, BO and TLBB. We have operated BO for more than 3 years, and we expect that it will gradually lose its attractiveness to users within the next one or two years. Revenues from TLBB, which was launched in 2007, represent approximately 84% of our total game revenues for 2007. We expect that revenue from TLBB will become mature during 2008.
In order to maintain the long-term profitability of our online game business, we will need to continually introduce new online games to attract game users and increase our game revenues. Though we have successfully launched our in-house developed game TLBB, we may fail to develop and launch additional new games in the market if we are unable to a) anticipate and catch up with future technical trends, new business models, and changed game players’ preferences and requirements, b) effectively plan and organize marketing and promotion activities and, c) differentiate our new games from existing games. If so, the profitability of our game business will be materially and adversely affected.
Furthermore, in order to sustain the revenues of TLBB, which constituted 84% of our total game revenue in 2007, we may need to trace and meet players’ preferences and needs in a timely manner; thus we must continually improve TLBB’s in-game quality and launch new features or new extension packs in order to retain existing users and attract new users. If we fail to meet our users’ preferences and needs, TLBB may lose its attraction for existing and potential users, which would have a significant adverse effect on our online game revenues.
Revenue recognition of online game operations depends on the data captured in the related billing systems. If such billing systems fail to operate effectively, the completeness and accuracy of the recognition of revenue will be materially affected.
We have adopted an item-based business model for our revenue derived from the online game operation. Under this item-based model, billing systems are required to capture data, such as items purchased, amount spent and amount accumulated by each individual user, which are critical for the calculation of revenue earned from time to time. If the related billing systems are damaged by system failure, network interruption, or virus infection, or invaded by a hacker, the integrity of data would be compromised, which in turn could have an adverse effect on our recognized game revenue.
We rely on wireless services for a significant portion of our revenues. Wireless revenues have decreased in prior periods and may decrease further in the future.
We derive a significant portion of our revenues from wireless services. We have derived our wireless revenues in prior periods from providing SMS, RBT, WAP, MMS and IVR, mainly consisting of news, weather forecast, chatting, entertainment information, music, ring tone, picture and logo downloads and various other mobile related products to mobile phone users and Personal Handy-phone System (or PHS) users. For the years ended December 31, 2007 and 2006, wireless revenues represented approximately 14% and 24%, respectively, of our total revenues.
Wireless revenues decreased in certain prior periods. Wireless revenues may decrease in the future due to the possibilities that:
•
Our consumers may not understand our services or the fees they are being charged, may not be satisfied with our services and/or may not use our services on a regular basis;
•
Consumers may cancel their services at any time without notice;
•
Revenues from new wireless services such as RBT, WAP, MMS and IVR may not continue to grow significantly and become a significant portion of our total wireless revenues;
•
Competitors, including mobile network operators, may launch competing or better products than ours at any time;
•
There are limited barriers to entry to the wireless services sector;
•
Changes in the billing practices or operational rules and procedures of any of the four mobile network operators on whom we rely for service delivery and fee collection - namely, CMCC, Unicom, CNC and China Telecom - could have a material impact on our wireless revenues. For instance, in July 2006, two major mobile network operators, CMCC and Unicom, introduced new policies on wireless value-added service, including extension of the trial period, double reminders for new monthly subscriptions, billing reminders to existing monthly subscribers and conversion of per message-based SMS subscriptions. In October 2006, the MII issued a guideline to regulate wireless value-added services, which reiterated policies carried on by major mobile network operators, including double confirmation, billing reminders, etc. On January 1, 2007, a notice of the MII, which focuses on the protection of mobile phone users’ right to select services and the
strengthening of regulation on billing procedure, came into effect. On May 17, 2007, CMCC initiated a new policy under which all WAP users are reminded of charges they may incur for WAP services. The policy has resulted in a decrease in traffic for the WAP portals, and in turn a decrease in subscriptions for our WAP services. We believe that our wireless revenues might be negatively affected by the implementation of these regulations and policies;
•
Changes in government policy could restrict or curtail the services which we provide. The MII has proposed requiring all handset users (including pre-paid mobile phone users) to register using their real names. If this requirement is implemented, it may cause the decrease of new customers, and in turn, reducing our wireless revenues;
•
Mobile network operators may impose penalties on wireless service providers, or SPs, for violating certain operating policies relating to the provision of wireless services. We have received several penalty notices from mobile network operators, claiming a breach of cooperation contracts and imposing both service suspension sanctions for a period of not more than a year and/or monetary penalties. There is no guarantee that we will not be subject to similar, or more severe, penalties from mobile network operators in the future, which could significantly impair our wireless business;
•
We may enter into cooperation agreements with mobile network operators on terms that are not favorable to us since we have limited bargaining power to negotiate contract terms. In addition, mobile network operators may unilaterally revise their agreement at any time. As a result of such contract terms, we could easily be found in breach of our agreement with an operator and may be subject to penalties; and
•
Mobile network operators may not enter new agreements or renew existing agreements with SPs with respect to wireless services. However, those mobile network operators will continue work with us to provide services and monthly statements. New or renewed agreements with mobile network operators could change in a way that would be unfavorable to us, or such agreements may not be entered into at all.
We rely on contracts with the mobile network operators in a number of ways with respect to our wireless services, including the billing of, and collection from, mobile phone users of wireless service fees. If our arrangements with mobile network operators were to be terminated, altered or not renewed, or if such operators did not provide continuous or adequate service, our revenues could be reduced.
Our wireless services depend mainly on the cooperation of mobile network operators such as CMCC, Unicom, CNC, China Telecom and their respective subsidiaries. We rely on mobile network operators in the following ways:
•
we use mobile network operators’ networks and gateways to provide wireless services;
•
we use and rely on mobile network operators’ billing systems to charge our subscribers through the subscribers’ mobile phone bills;
•
we rely on mobile network operators’ collection proxy services to collect payments from subscribers; and
•
we rely on mobile network operators’ infrastructure to further develop our wireless services.
We face significant risks with respect to our arrangements with mobile network operators which could adversely affect our wireless revenues. Such risks include the following:
•
Mobile network operators have changed their operating rules and may make further changes at any time. Such previous or any future changes could result in our being required to pay penalties for breaching or being alleged to have breached certain provisions of our agreements with the mobile network operators under new or revised operation rules, or having our service discontinued with or without notice. Changes in these operating rules could also have a material impact on our wireless revenues;
•
We provide wireless services through our Website and record the delivery of the service in our internal systems. However, in order to recognize revenues and receive payment for services provided, we rely on billing confirmations from mobile network operators as to the actual amount of services they have billed to their mobile customers. We are unable to collect wireless service fees from an operator in certain circumstances due to technical issues with the operator’s network. We refer to these failures as an operator’s “failure rate”, which can vary from operator to operator. An operator’s failure rate can vary from month to month, ranging from 0% to 98% and may change at any time without notice. If an operator encounters technical problems, increases in the failure rate for that operator could occur;
•
The service fees we pay for using an operator’s infrastructure are set on the basis of negotiation of annual contracts. Our negotiation leverage is limited and if an operator increases its service fees or does not comply with the terms of our contract, our gross margin and profitability could be materially reduced. It is possible that some subsidiaries of the mobile network operators may consider increasing their service fees;
•
We are required to follow the operators’ guidance in setting up wireless service fees. We also rely on the mobile network operators to collect the fees on our behalf which they have billed to our mobile customers. If an operator requires us to reduce the wireless service fees charged to mobile customers, disallows us from billing of certain inactive customers, refuses to pay us, requires us to share bad debts expenses, or, limits the amount of wireless service fees which can be billed or requires us to comply with any new billing rules, our wireless revenues could be adversely affected;
•
An operator’s refusal to allow us to supply certain services could disrupt our wireless services. For example, during the period from September 1, 2004 to July 31, 2005, our MMS services were temporarily suspended by CMCC, based on allegations that Beijing Sohu, which was one of our VIEs at the time, breached certain provisions of its agreement with a CMCC subsidiary;
•
An operator could launch competing services at any time and could work with content providers directly so that SPs’ abilities to diversify their products might be limited. For example, in July 2006, CMCC introduced M.Music, an integrated music service platform which CMCC works directly with music record companies to provide downloads of various songs and music. In December 2006, CMCC introduced its own WAP channel, “WAP Premier Select”, which is placed in prominent positions on Monternet and directly competes with SPs. If mobile network operators were unwilling to work with us, we would not be able to find substitute partners; and
•
CMCC set up rules for ranking of WAP service providers on its Monternet browser, which has a significant impact on WAP revenues. CMCC may change the rules at any time to affect the rank of the top five listings. As a result, the growth of our WAP revenues was lower than expected and we may lose our existing ranking because of lower visit rates.
Our strategy of acquiring complementary assets, technologies and businesses may fail and result in equity or earnings dilution.
As a component of our growth strategy, we have acquired and intend to actively identify and acquire assets, technologies and businesses that are complementary to our existing portal business. Our acquisitions could result in the use of substantial amounts of cash, potentially dilutive issuances of equity securities, significant impairment losses related to goodwill or amortization expenses related to intangible assets and exposure to undisclosed or potential liabilities of acquired companies. Moreover, the resources expended in identifying and consummating acquisitions may be significant. Furthermore, any acquisition we decide to pursue may be subject to the approval of the relevant PRC governmental authorities, as well as any applicable PRC rules and regulations. Considering the fast changing legal environment, our acquisition may be subject to government’s further scrutiny and the acquisition structures we used to adopt may be found to be inappropriate.
We may be required to record a charge to earnings if we must reassess our goodwill or amortizable intangible assets arising from acquisitions.
We are required under generally accepted accounting principles to review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least annually. Factors that may be considered a change in circumstances indicating that the carrying value of our amortizable intangible assets may not be recoverable include a decline in stock price and market capitalization and slower growth rates in our industry. We may be required to record a charge to earnings in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined. As of December 31, 2007, our goodwill and amortizable intangible assets arising from acquisitions were approximately $61.7 million.
Changes in accounting rules for share-based compensation may adversely affect our operating results, our stock price and our competitiveness in the employee marketplace.
Our performance is largely dependent on talented and highly skilled individuals. Our future success depends on our continuing ability to identify, develop, motivate and retain highly skilled personnel for all areas of our organization. We have a history of using employee stock options and restricted stock units to align employees’ interest with the interests of our shareholders and encourage quality employees to join us and retain our quality employees by providing competitive compensation packages. On January 1, 2006, we adopted SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based compensation based on estimated fair values. As a result, our operating results contain a charge for share-based compensation expense related to employee stock options and restricted stock units. The recognition of share-based compensation in our statement of operations would have a negative effect on our reported results and earnings per share, which could in turn negatively affect our stock
price. On the other hand, if we alter our employee stock incentive plan to minimize the share-based compensation expenses, it may limit our ability to continue to use share-based awards as a tool to attract and retain our employees, and it may adversely affect our operations.
Our failure to manage growth and diversify our business could harm us.
We have experienced dramatic growth in personnel since our inception and we expect to continue to hire additional personnel in selected areas. This growth requires significant time and resource commitments from us and our senior management. If we are unable to effectively manage a large and geographically dispersed group of employees or anticipate our future growth, our business could be adversely affected.
Additionally, our business relies on our financial reporting and data systems (including our systems for billing users of our fee-based services), which have grown increasingly complex in the recent past due to acquisitions and the diversification and complexity of our business. Our ability to operate our business efficiently depends on these systems, and if we are unable to adapt to these changes, our business could be adversely affected.
If we fail to establish and maintain relationships with content, technology or infrastructure providers, we may not be able to attract and retain users.
Although, we may secure more attractive, high-quality music and content, we will still need to rely on a number of third party relationships to attract traffic and provide content in order to make our Websites more attractive to users and advertisers. Most of our arrangements with content providers are short-term and may be terminated at the convenience of the other party. Some content providers have increased the fees they charge us for their content. This trend could increase our costs and operating expenses and could adversely affect our ability to obtain content at an economically acceptable cost. We have also entered into exclusive agreements with some of our premier content providers. If we are not able to renew our exclusive deals or premier content become exclusive to our competitors, our attractiveness to users will be severely impaired. Except for the exclusive content, much of the third party content provided to our Websites is also available from other sources or may be provided to other Internet companies. If other Internet companies present the same or similar content in a superior manner, it would adversely affect our visitor traffic.
Our business also depends significantly on relationships with leading technology and infrastructure providers and the licenses that the technology providers have granted to us. Our competitors may establish the same relationships as we have, which may adversely affect us. We may not be able to maintain these relationships or replace them on commercially attractive terms. For example, there are uncertainties in the wireless industry, such as the delayed issuance of 3G licenses and rumors concerning the possible restructuring of state-owned telecommunication companies, that increase the risk that we will not be able to maintain co-operative relationships with mobile network operators.
We depend on key personnel and our business may be severely disrupted if we lose the services of our key executives and employees.
Our future success is heavily dependent upon the continued service of our key executives, particularly Dr. Zhang, who is the founder, Chief Executive Officer, Chairman of the Board, and a major shareholder of our company and a direct and indirect major shareholder of High Century, Sohu Internet, Tu Xing Tian Xia and Feng Yang Tian Lang. We rely on his expertise in our business operations, and on his personal relationships with the relevant regulatory authorities, our customers and suppliers. If one or more of our key executives and employees are unable or unwilling to continue in their present positions, we may not be able to replace them easily and our business may be severely disrupted. In addition, if any of our key executives or employees joins a competitor or forms a competing company, we may lose customers and suppliers and incur additional expenses to recruit and train personnel. Each of our executive officers has entered into an employment agreement and a confidentiality, non-competition and non-solicitation agreement with us. However, the degree of protection afforded to an employer pursuant to confidentiality and non-competition undertakings governed by PRC law may be more limited when compared to the degree of protection afforded under the laws of other jurisdictions. We do not maintain key-man life insurance for any of our key executives.
We also rely on a number of key technology staff for the operation of Sohu. Given the competitive nature of the industry, the risk of key technology staff leaving Sohu is high and could have a disruptive impact on our operations.
Rapid growth and a rapidly changing operating environment strain our limited resources.
We have limited operational, administrative and financial resources, which may be inadequate to sustain the growth we want to achieve. As the demands of our audience and the needs of our customers change, and as the number of our users and volume of online advertising, and wireless activities increase, we will need to increase our investment in our network infrastructure, facilities and other areas of operations. If we are unable to manage our growth and expansion effectively, the quality of our services could deteriorate and our business may suffer. Our future success will depend on, among other things, our ability to:
•
adapt our services and maintain and improve the quality of our services;
•
protect our Website from hackers and unauthorized access;
•
continue training, motivating and retaining our existing employees and attract and integrate new employees; and
•
develop and improve our operational, financial, accounting and other internal systems and controls.
Risks Related to China’s Telecommunications Infrastructure
The telecommunications infrastructure in China, which is not as well developed as in the United States, may limit our growth.
The telecommunications infrastructure in China is not well developed. Our growth will depend on the PRC government and state-owned enterprises establishing and maintaining a reliable Internet and telecommunications infrastructure to reach a broader base of Internet users in China. The Internet infrastructure, standards, protocols and complementary products, services and facilities necessary to support the demands associated with continued growth may not be developed on a timely basis or at all by the PRC government and state-owned enterprises.
We depend on CNC, China Telecom and CERNET for telecommunications services, and any interruption in these services may result in severe disruptions to our business.
Although private Internet service providers exist in China, almost all access to the Internet is maintained through CNC, China Telecom and CERNET, under the administrative control and regulatory supervision of the MII. We rely on this infrastructure and CNC, China Telecom and CERNET to provide data communications capacity primarily through local telecommunications lines. Although the government has announced aggressive plans to develop the national information infrastructure, this infrastructure may not be developed and the Internet infrastructure in China may not be able to support the continued growth of Internet usage. In addition, we will have no access to alternative networks and services, on a timely basis if at all, in the event of any infrastructure disruption or failure.
We have signed Bandwidth Provision and Server Hosting Agreements with CNC, China Telecom and CERNET. Under these agreements, we established four main service provision centers to maintain most of our servers in Beijing. However, as there are limited telecommunication infrastructure service providers, we may not be able to lease additional bandwidth on acceptable terms, on a timely basis, or at all. If we are not able to lease additional bandwidth, the development of our business can be affected.
The high cost of Internet access may limit the growth of the Internet in China and impede our growth.
Access to the Internet in China remains relatively expensive, and may make it less likely for users to access and transact business over the Internet. Unfavorable rate developments could further decrease our visitor traffic and our ability to derive revenues from transactions over the Internet.
To the extent we are unable to scale our systems to meet the increasing PRC Internet population, we will be unable to expand our user base and increase our attractiveness to advertisers and merchants.
As Web page volume and traffic increase in China, we may not be able to scale our systems proportionately. To the extent we do not successfully address our capacity constraints, our operations may be severely disrupted, and we may not be able to expand our user base and increase our attractiveness to advertisers and merchants.
Unexpected network interruptions caused by system failures may result in reduced visitor traffic, reduced revenue and harm to our reputation.
Our Website operations are dependent upon Web browsers, Internet service providers, content providers and other Website operators in China, which have experienced significant system failures and system outages in the past. Our users have in the past experienced difficulties due to system failures unrelated to our systems and services. Any system failure or inadequacy that causes interruptions in the availability of our services, or increases the response time of our services, as a result of increased traffic or otherwise, could reduce our user satisfaction, future traffic and our attractiveness to users and advertisers.
Our operations are vulnerable to natural disasters and other events, as we only have limited backup systems and do not maintain any backup servers outside of China.
We have limited backup systems and have experienced system failures and electrical outages from time to time in the past, which have disrupted our operations. Most of our servers and routers are currently hosted in a single location within the premises of Beijing Telecom Administration (or BTA). Our disaster recovery plan cannot fully ensure safety in the event of damage from fire, floods, typhoons, earthquakes, power loss, telecommunications failures, break-ins and similar events. If any of the foregoing occurs, we may experience a complete system shutdown. We do not carry any business interruption insurance. To improve the performance and to prevent disruption of our services, we may have to make substantial investments to deploy additional servers or one or more copies of our Websites to mirror our online resources.
Although we carry property insurance with low coverage limits, our coverage may not be adequate to compensate us for all losses, particularly with respect to loss of business and reputation, that may occur.
Our network operations may be vulnerable to hacking, viruses and other disruptions, which may make our products and services less attractive and reliable.
Internet usage could decline if any well-publicized compromise of security occurs. “Hacking” involves efforts to gain unauthorized access to information or systems or to cause intentional malfunctions or loss or corruption of data, software, hardware or other computer equipment. Hackers, if successful, could misappropriate proprietary information or cause disruptions in our service. We may be required to expend capital and other resources to protect our Website against hackers. We cannot assure you that any measure we may take will be effective. In addition, the inadvertent transmission of computer viruses could expose us to a material risk of loss or litigation and possible liability, as well as materially damage our reputation and decrease our user traffic.
Risks Related to China’s Regulation Environment
If our current ownership structure is found to be in violation of current or future PRC laws, rules or regulations regarding the legality of foreign investment in the PRC Internet sector, we could be subject to severe penalties.
We conduct our Internet and value-added telecommunication operations solely in the PRC through our indirect wholly owned subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age (or collectively PRC subsidiaries), and VIEs, High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information, 21 East Beijing, Gamease Age and New 21 East. We are a Delaware corporation, while Sohu Hong Kong, our indirect wholly owned subsidiary and the parent company of, Sohu Era, Sohu Media and Sohu Software, and TL Age HK, our indirect wholly owned subsidiary and the parent company of AmazGame Age, are both Hong Kong corporations and foreign persons under PRC law. In order to meet ownership requirements under PRC law which restrict or prohibit wholly foreign owned enterprises, or WFOEs, from operating in certain industries such as Internet information, wireless, Internet access, and certain other industries, our VIEs are companies incorporated in the PRC and owned by Dr. Zhang and certain other employees of Sohu, rather than by Sohu.
The PRC began several years ago to regulate its Internet sector by making pronouncements or enacting regulations regarding the legality of foreign investment in the PRC Internet sector and the existence and enforcement of content restrictions on the Internet. We believe that our current ownership structure complies with all existing PRC laws, rules and regulations. There are, however, substantial uncertainties regarding the interpretation of current PRC Internet laws and regulations. The PRC government may issue new interpretations of the regulations regarding supervision of the Information industry from time to time. In July 2006, the MII issued a notice to strengthen management of foreign investment in and operation of value-added telecommunication services. The notice emphasizes that foreign investors who wish to engage in value-added telecommunication services must strictly follow the relevant rules and regulations on foreign investment in telecommunication sectors. The notice also prohibits domestic telecommunication services providers from leasing, transferring or selling telecommunications business operating licenses to any foreign investor in any form, or providing any resources, sites or facilities to any foreign investor for their illegal operation of a telecommunications business in China. According to the notice, either the holder of a value-added telecommunication service license or its shareholders must directly own the domain names and trademarks used by such license holders in their provision of Value-added Telecommunication Services. The notice further requires each license holder to have the necessary facilities, including servers, for its approved business operations and to maintain such facilities in the regions covered by its license. Value-added services license holders are required to evaluate the compliance with the requirements set forth in the notice. We are in the process of transferring several of our domain names and trademarks to Sohu Internet, which licensed the same to Sohu Era and Sohu Media, and we may modify other certain aspects of our business structure in order to further comply with these requirements. In addition, new PRC Internet and foreign exchange laws and regulations were recently adopted. Accordingly, it is possible that the PRC government may ultimately take a view contrary to ours.
In addition, under the agreement reached in November 1999 between the PRC and the United States concerning the United States’ support of China’s entry into the World Trade Organization, or WTO, regulation of foreign investment in PRC Internet services is to be liberalized to allow for 30% foreign ownership in key telecommunication services, including PRC Internet ventures, for the first year after China’s entry into the WTO, 49% in the second year and 50% thereafter. China officially entered the WTO on December 11, 2001. However, the implementation of China’s WTO accession agreements is still subject to various conditions.
Accordingly, it is possible that the relevant PRC authorities could, at any time, assert that any portion or all of the Sohu PRC subsidiaries’ and Sohu VIEs’ existing or future ownership structure and businesses violate existing or future PRC laws, regulations or policies. It is also possible that the new laws or regulations governing the PRC Internet sector that have been adopted or may be adopted in the future will prohibit or restrict foreign investment in, or other aspects of, any of our PRC subsidiaries’ and VIEs’ current or proposed businesses and operations. In addition, any such new laws and regulations may be retroactively applied to us and our PRC subsidiaries and VIEs.
If we or any of our PRC subsidiaries and VIEs were found to be in violation of any existing or future PRC laws or regulations, the relevant PRC authorities would have broad discretion in dealing with such violations, including, without limitation, the following:
•
levying fines;
•
confiscating our income;
•
revoking our licenses;
•
shutting down our servers and/or blocking our Websites;
•
requiring us to restructure our ownership structure or operations; and
•
requiring us to discontinue any portion or all of its Internet and value-added telecommunication businesses.
We may rely on dividends and other distributions on equity paid by Sohu.com Limited, our wholly owned subsidiary, to fund any cash requirements we may have. We may not be able to obtain cash from distributions to the extent such distributions are restricted by PRC law or future debt covenants. Any dividend received by Sohu.com Inc. may be subject to US tax at a 34% to 35% rate.
We are a holding company with no operating assets other than investments in Chinese operating entities through our intermediate holding company, Sohu.com Limited, our wholly-owned subsidiary in the Cayman Islands, and our VIEs, High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information, 21 East Beijing, Gamease Age and New 21 East. We may need to rely on dividends and other distributions on equity paid by Sohu.com Limited for our cash requirements in excess of any cash raised from investors and retained by us. If Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age incur debt on their own behalf in the future, the instruments governing the debt may restrict Sohu Era’s, Sohu Media’s, Sohu Software’s, Sogou Technology’s, Go2Map Software’s and AmazGame Age’s ability to pay dividends or make other distributions to us through the immediate companies.
In addition, PRC legal restrictions permit payment of dividends by Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software, and AmazGame Age only out of their net income, if any, determined in accordance with PRC accounting standards and regulations. Under PRC law, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software, and AmazGame Age are also required to set aside 10% of their net income each year to fund certain reserve funds until these reserves equal 50% of the amount of paid-in capital. These reserves are not distributable as cash dividends. Further, the Corporate Income Tax Law effective from January 1, 2008 imposes a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China, which were exempted under the previous income tax laws and rules. A lower withholding tax rate will be applied if there is a tax treaty arrangement between mainland China and the jurisdiction of the foreign holding company. Holding companies in Hong Kong, for example, will be subject to a 5% rate. Most of our China-based subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age are invested by immediate foreign holding companies in Hong Kong, except for Sogou Technology. All of these foreign invested enterprises will be subject to the withholding tax on January 1, 2008, if they declare dividends to their immediate foreign holding companies. Furthermore, subject to possible reduction to the extent that our PRC subsidiaries pay a tax in China and would therefore be entitled to a foreign tax credit, dividends received by Sohu.com Inc. would be subject to taxation at United States tax rates of 34% or 35%. We do not expect any dividends or other distributions on equity from Sohu.com Limited or the operating entities in the foreseeable future.
We may be unable to collect long-term loans to officers and employees or exercise management influence associated with High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age.
As of December 31, 2007, Sohu had outstanding long-term loans of $11.4 million to Dr. Zhang, Sohu’s Chief Executive Officer and a major Sohu shareholder, and certain of our employees. The long-term loans are used to finance investments in High Century, which is owned 80% by Dr. Zhang and 20% by an employee; Sohu Entertainment, which is owned by two of our employees; Goodfeel, which is owned by two of our employees; Huohu, which is owned 75% by Sohu Era and 25% by an employee; Sogou Information, which is owned by two of our employees, and Gamease Age, which is owned by two of our employees. High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age are used to facilitate our participation in telecommunications, Internet content and certain other businesses in China where foreign ownership is either prohibited or restricted.
The loan agreements contain provisions that, subject to PRC laws, (i) the loans can only be repaid to us by transferring the shares of High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information or Gamease Age to us; (ii) the shares of High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information or Gamease Age cannot be transferred without our approval; and (iii) we have the right to appoint all directors and senior management personnel of High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age. Dr. Zhang and the other employee borrowers have pledged all of their shares in High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age as collateral for the loans and the loans bear no interest and are due on demand after November 2003 in the case of High Century; after November 2005 in the case of Huohu; after August 2006 in the case of Sogou Information; after October 2006 in the case of Goodfeel; after November 2006 in the case of Sohu Entertainment; after September 2008 in the case of Gamease Age and the earlier of a demand or, in any case, at such time as Dr. Zhang or the other employee borrowers, as the case may be, is not an employee of Sohu. Sohu does not intend to request repayment of the loans as long as PRC regulations prohibit it from directly investing in businesses being undertaken by the VIEs.
Because these loans can only be repaid by the borrowers’ transferring the shares of the various entities, our ability to ultimately realize the effective return of the amounts advanced under these loans will depend on the profitability of High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age is uncertain.
Furthermore, because of uncertainties associated with the PRC law, ultimate enforcement of the loan agreements is uncertain. Accordingly, we may never be able to collect these loans or exercise influence over High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age.
We depend upon contractual arrangements with High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information and Gamease Age for the success of our business and these arrangements may not be as effective in providing operational control as direct ownership of these businesses and may be difficult to enforce.
Because we conduct our Internet operations only in the PRC, and are restricted or prohibited by the PRC government from owning Internet content or telecommunication operations in the PRC, we are dependent on High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information and Gamease Age, in which we have no direct ownership interest, to provide those services through contractual agreements between the parties. These arrangements may not be as effective in providing control over our Internet content or telecommunications operations as direct ownership of these businesses. For example, some of our subsidiaries and VIEs could fail to take actions required for our business, such as entering into content development contracts with potential content suppliers or failing to maintain the necessary permit for the content servers. If High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information and Gamease Age fail to perform its obligations under these agreements, we may have to rely on legal remedies under PRC law. We cannot assure you that such remedies under PRC law would be effective or sufficient.
Dr. Zhang, our Chief Executive Officer and a major shareholder of our company, is also the direct and indirect majority shareholder of High Century, Sohu Internet, Tu Xing Tian Xia and Feng Yang Tian Lang. As a result, our contractual relationships with those companies could be viewed as entrenching his management position or transferring certain value to him, especially if any conflict with him arises.
If we are found to be in violation of current or future PRC laws, rules or regulations regarding Internet-related services and telecom-related activities, we could be subject to severe penalties.
The PRC has enacted regulations that apply to Internet-related services and telecom-related activities. While many aspects of these regulations remain unclear, they purport to limit and require licensing of various aspects of the provision of Internet information and content, online advertising, online game and value-added telecommunication services. In addition, the PRC government may promulgate new laws, rules or regulations at any time. If these current or future laws, rules or regulations regarding Internet-related activities, are interpreted to be inconsistent with our ownership structure and/or our business operations, our business will be severely
impaired and we could be subject to severe penalties. For example, the State Press and Publication Administration temporarily suspended the issuance of Online Publication Licenses, which caused us to be unable to obtain such license. As an alternative, we signed a contract with a third party, who holds such license, to publish our online game. We believe this practice has been adopted by most of our competitors and other Internet companies. However, it is unclear if the State Press and Publication Administration will permit this practice. If the State Press and Publication Administration prohibits us from publishing our game through a third party with a license, if the third party terminates the agreement for publishing our online game, or if we fail to maintain any other required permits or approvals, we may be subject to various penalties, including fines and the discontinuation of or restrictions on our operations. Any such disruption in our business operations would materially and adversely affect our business, financial condition and results of operations. In addition, as the online game industry is at an early stage of development in China, the PRC government might release new laws, new regulations and policies from time to time to implement restrictions and further regulation on the online games industry. For example, online games companies are required to install an “anti-fatigue system”, which discourages game participants from playing games for more than five hours per day.
In addition, the PRC government has implemented a compulsory requirement that online game players register their real names and provide ID numbers when playing games. With this requirement as to real-name registration for online game players, the government implemented a rating system for online games. For those online games rated as not suitable for children under the age of 18, children under the age of 18 will be unable to access such game if a real name registration is in place. As a result, our revenues from online games may be adversely affected. In addition, we may be required to apply for a new license or new qualification or transfer from an old type of license to a new type of license at any time as a result of the requirements of newly promulgated laws or new regulations. There often is a lengthy period between the enactment of such new requirements and the final issuance of any required license or qualification. Although effectiveness of any such new license ordinarily will be as of the date of filing of the application, we may be held liable for operating without a proper license and may be fined for any operations conducted during the application period.
We may not be able to collect payments of our wireless fees if the PRC government determines that our existing ownership structure does not comply with PRC laws, rules or regulations.
As discussed above, the PRC began several years ago to regulate its Internet sector by making pronouncements or enacting regulations regarding the legality of foreign investment in the PRC Internet sector. We believe that our current ownership structure complies with all existing PRC laws, rules and regulations. There are, however, substantial uncertainties regarding the interpretation of current PRC Internet laws and regulations. It is possible that the PRC government’s view will ultimately be contrary to ours. If the PRC government were to take a contrary view, we might not be able to collect payments of our wireless fees, which we receive from Sohu Internet and Goodfeel, which in turn collect the fees from mobile network operators.
Even if we are in compliance with PRC governmental regulations relating to licensing and foreign investment prohibitions, the PRC government may prevent us from distributing, and we may be subject to liability for, content that it believes is inappropriate.
The PRC has enacted regulations governing Internet access and the distribution of news and other information. In the past, the PRC government has stopped the distribution of information over the Internet that it believes to violate PRC law, including content that is obscene, incites violence, endangers national security, is contrary to the national interest or is defamatory. In addition, we may not publish certain news items, such as news relating to national security, without permission from the PRC government. Furthermore, the Ministry of Public Security has the authority to make any local Internet service provider block any Website maintained outside the PRC at its sole discretion. Even if we comply with PRC governmental regulations relating to licensing and foreign investment prohibitions, if the PRC government were to take any action to limit or prohibit the distribution of information through our network or to limit or regulate any current or future content or services available to users on our network, our business would be harmed.
We are also subject to potential liabilities for content on our Websites that is deemed inappropriate and for any unlawful actions of our subscribers and other users of our systems under regulations promulgated by the MII, such potential liabilities including, but not limited to, the imposition of fines or even the shutting down of the Website.
Furthermore, we are required to delete content that clearly violates the laws of the PRC and report content that we suspect may violate PRC law. We may have difficulty determining the type of content that may result in liability for us and, if we are wrong, we may be prevented from operating our Websites.
We may not have exclusive rights over the marks that are crucial to our business, including but not limited to “Sohu.com”, “Sogou”, “17173”, “Focus.cn”, “Goodfeel” and “Go2Map”.
We have applied for the registration of our key marks in the PRC, including but not limited to Sohu.com, Sogou, 17173, Focus.cn, Goodfeel and Go2Map, so as to establish and protect our exclusive rights to the marks. We have succeeded in registering the marks
“Sohu.com”, “17173”, “Focus.cn”, “GoodFeel” and “Go2Map” in the PRC under certain classes. The applications for the registration of the other marks or some marks under other classes are still under examination by the Trademark Office of PRC. Completion of the registrations is subject to the Trademark Office of PRC’s determination that there are no prior rights in the PRC. Any rejection of these applications could adversely affect our rights to these marks.
Unauthorized use of our intellectual property by third parties, and the expenses incurred in protecting our intellectual property rights, may adversely affect our business.
We regard our copyrights, service marks, trademarks, trade secrets and other intellectual property as critical to our success. Unauthorized use of our intellectual property by third parties may adversely affect our business and reputation. We rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, customers, business partners and others to protect our intellectual property rights. Despite our precautions, it may be possible for third parties to obtain and use our intellectual property without authorization. Furthermore, the validity, enforceability and scope of protection of intellectual property in Internet-related industries are uncertain and still evolving. In particular, the laws of the PRC and certain other countries are uncertain or do not protect intellectual property rights to the same extent as do the laws of the United States. Moreover, litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Future litigation could result in substantial costs and diversion of resources.
We may be subject to intellectual property infringement claims, which may force us to incur substantial legal expenses and, if determined adversely against us, materially disrupt our business.
We cannot be certain that our products, services and intellectual property used in our normal course of business do not or will not infringe valid patents, copyrights or other intellectual property rights held by third parties. We have in the past been, are currently, and may in the future be, subject to claims and legal proceedings relating to the intellectual property of others in the ordinary course of our business. In particular, if we are found to have violated the intellectual property rights of others, we may be enjoined from using such intellectual property, may be ordered to pay a fine and may incur licensing fees or be forced to develop alternatives. We may incur substantial expenses in defending against these third party infringement claims, regardless of their merit. Successful infringement claims against us may result in substantial monetary liability or may materially disrupt the conduct of our business by restricting or prohibiting our use of the intellectual property in question. For example, during 2006 five United States movie companies commenced a lawsuit against us in the PRC alleging that a movie download service we had been providing infringed their copyrights in the movies. In December 2006, the court decided the case against us, and ordered us to pay damages of approximately $138,000 to the U.S. movie companies. In addition, in 2007 a writer brought a lawsuit against in China claiming that we violated his copyright to 190 SMS messages in 2007. The Chinese court decided the case against us, and we paid damages of approximately $13,000 to the writer. In addition, we provide search engine facilities capable of locating and accessing links to download MP3 music, movies, images and other multimedia files and/or other content hosted on third party Websites, which may be protected by copyright law. Although, in a recent judgment in China, the court deemed that one of the industry participants was not infringing the rights of copyright owners for its MP3 search services, we may face claims or lawsuits relating to our MP3 services in the future.
We may be subject to, and may expend significant resources in defending against claims based on the content and services we provide over all of our Websites.
As our services may be used to download and distribute information to others, there is a risk that claims may be made against us for defamation, negligence, copyright or trademark infringement or other claims based on the nature and content of such information. Furthermore, we could be subject to claims for the online activities of our visitors and incur significant costs in their defense. In the past, claims based on the nature and content of information that was posted online by visitors have been made in the United States against companies that provide online services. We do not carry any liability insurance against such risks.
We could be exposed to liability for the selection of listings that may be accessible through our Websites or through content and materials that our visitors may post in classifieds, message boards, chat rooms or other interactive services. If any information provided through our services contains errors, third parties may make claims against us for losses incurred in reliance on the information. We also offer Web-based e-mail and subscription services, which exposes us to potential liabilities or claims resulting from:
•
unsolicited e-mail;
•
lost or misdirected messages;
•
illegal or fraudulent use of e-mail; or
•
interruptions or delays in e-mail service.
Investigating and defending any such claims may be expensive, even if they do not result in liability.
Activities of Internet content providers are or will be subject to additional PRC regulations, which have not yet been put into effect. Our operations may not be consistent with these new regulations when put into effect, and, as a result, we could be subject to severe penalties.
The MII has stated that the activities of Internet content providers are subject to regulation by various PRC government authorities, depending on the specific activities conducted by the Internet content provider. Various government authorities have stated publicly that they are in the process of preparing new laws and regulations that will govern these activities. The areas of regulation currently include online advertising, online news reporting, online publishing, provision of online or wireless music, online securities trading, the provision of industry-specific (e.g., drug-related) information over the Internet and foreign investment in value-added telecommunication services. For instance, the MOC issued “Several Opinions of Development and Supervision of Online Music” in November 2006. In accordance with the requirements of the MOC, we have submitted most of the online music which we distributed in the PRC online or through wireless to the MOC for censoring and recording in March 2007. We may be required to be responsible for supervising nonprofit users’ distribution of online music on our portal. If we fail to comply with these requirements, we may be fined. Other aspects of our online operations may be subject to regulations in the future. Our operations may not be consistent with these new regulations when put into effect and, as a result, we may be subject to severe penalties as discussed above.
Regulation and censorship of information distribution in China may adversely affect our business.
China has enacted regulations governing Internet access and the distribution of news and other information. Furthermore, the Propaganda Department of the Chinese Communist Party has been given the responsibility to censor news published in China to ensure, supervise and control a particular political ideology. In addition, the MII has published implementing regulations that subject online information providers to potential liability for contents included in their portals and the actions of subscribers and others using their systems, including liability for violation of PRC laws prohibiting the distribution of content deemed to be socially destabilizing. Furthermore, the MII may implement a requirement that users of blogs register under their real names. If such a regulation is implemented, our business may be negatively affected due to a decrease in the number of blog users. Furthermore, because many PRC laws, regulations and legal requirements with regard to the Internet are relatively new and untested, their interpretation and enforcement may involve significant uncertainty. In addition, the PRC legal system is a civil law system in which decided legal cases have limited binding force as legal precedents. As a result, in many cases a Website operator may have difficulties determining the type of content that may subject it to liability.
Periodically, the Ministry of Public Security has stopped the distribution over the Internet of information which it believes to be socially destabilizing. The Ministry of Public Security has the authority to require any local Internet service provider to block any Website maintained outside China at its sole discretion. If the PRC government were to take action to limit or eliminate the distribution of information through our portal or to limit or regulate current or future applications available to users of our portal, our business would be adversely affected.
The State Secrecy Bureau, which is directly responsible for the protection of state secrets of all PRC government and Chinese Communist Party organizations, is authorized to block any Website it deems to be leaking state secrets or failing to meet the relevant regulations relating to the protection of state secrets in the distribution of online information. Under the applicable regulations, we may be held liable for any content transmitted on our portal. Furthermore, where the transmitted content clearly violates the laws of the PRC, we will be required to delete it. Moreover, if we consider transmitted content suspicious, we are required to report such content. We must also undergo computer security inspections, and if we fail to implement the relevant safeguards against security breaches, we may be shut down. In addition, under recently adopted regulations, Internet companies which provide bulletin board systems, chat rooms or similar services, such as our company, must apply for the approval of the State Secrecy Bureau. As the implementing rules of these new regulations have not been issued, we do not know how or when we will be expected to comply, or how our business will be affected by the application of these regulations.
Political, economic and social policies of the PRC government could affect our business.
All of our business, operating assets, fixed assets and operations are located in China, and all of our revenues are derived from our operations in China. Accordingly, our business may be adversely affected by changes in political, economic or social conditions in China, adjustments in PRC government policies or changes in laws and regulations.
The economy of China differs from the economies of most countries belonging to the Organization for Economic Cooperation and Development in a number of respects, including:
•
structure;
•
level of government involvement;
•
level of development;
•
level of capital reinvestment;
•
growth rate;
•
control of foreign exchange; and
•
methods of allocating resources.
Since 1949, China has been primarily a planned economy subject to a system of macroeconomic management. Although the PRC government still owns a significant portion of the productive assets in China, economic reform policies since the late 1970s have emphasized decentralization, autonomous enterprises and the utilization of market mechanisms. We cannot predict the future effects of the economic reform and macroeconomic measures adopted by the PRC government on our business or results of operations. Furthermore, the PRC government has begun to pay more attention to social issues in recent years and has promulgated or may promulgate additional laws or regulations in this area, which could affect our business in China. For example, in July 2007, the PRC government issued the new Employment Contract Law, effective from January 1, 2008, providing more employment protection to employees in China. We believe that this will enhance our general staff moral and loyalty. At the same time, however, we may incur additional staff costs in the future.
The PRC legal system embodies uncertainties which could limit the legal protections available to us and you, or could lead to penalties on us.
The PRC legal system is a civil law system based on written statutes. Unlike common law systems, it is a system in which decided legal cases have little precedential value. In 1979, the PRC government began to promulgate a comprehensive system of laws and regulations governing economic matters in general. Our PRC operating subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age are wholly-foreign owned enterprises, or WFOEs, which are enterprises incorporated in mainland China and wholly-owned by our indirect subsidiary, Sohu Hong Kong. Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age are subject to laws and regulations applicable to foreign investment in mainland China. In addition, all of our subsidiaries and VIEs are incorporated in China and subject to all applicable Chinese laws and regulation. Because of the relatively short period for enacting such a comprehensive legal system, it is possible that the laws, regulations and legal requirements are relatively recent, and their interpretation and enforcement involve uncertainties. These uncertainties could limit the legal protections available to us and other foreign investors, including you, and may lead to penalties imposed on us because of the different understanding between the relevant authority and us. For example, according to current tax laws and regulation, we are responsible to pay business tax on a “Self-examination and Self-application” basis. However, since there is no clear guidance as to the applicability of those preferential treatments, we may be found in violation of the interpretation of local tax authorities with regard to the scope of taxable services and the percentage of tax rate and therefore might be subject to penalties, including but not limited to monetary penalties. In addition, we cannot predict the effect of future developments in the PRC legal system, particularly with regard to the Internet, including the promulgation of new laws, changes to existing laws or the interpretation or enforcement thereof, or the preemption of local regulations by national laws.
It may be difficult to enforce any civil judgments against us or our board of directors or officers, because most of our operating and/or fixed assets are located outside of the United States.
Although we are incorporated in the State of Delaware, most of our operating and fixed assets are located in the PRC. As a result, it may be difficult for investors to enforce judgments outside the United States obtained in actions brought against us in the United States, including actions predicated upon the civil liability provisions of the federal securities laws of the United States or of the securities laws of any state of the United States. In addition, certain of our directors and officers (principally based in the PRC) and all or a substantial portion of their assets are located outside the United States. As a result, it may not be possible for investors to effect service of process within the United States upon those directors and officers, or to enforce against them or us judgments obtained in United States courts, including judgments predicated upon the civil liability provisions of the federal securities laws of the United States or of the securities laws of any state of the United States. We have been advised by our PRC counsel that, in their opinion, there is doubt as to the enforceability in the PRC, in original actions or in actions for enforcement of judgments of United States courts, of civil liabilities predicated solely upon the federal securities laws of the United States or the securities laws of any state of the United States.
If we cannot meet certain requirements of the Corporate Income Tax Law, our effective tax for 2008 and beyond would be increased significantly.
In March 2007, the Chinese government enacted the Corporate Income Tax Law, and promulgated related regulations, which were effective January 1, 2008. The Corporate Income Tax Law, among other things, imposes a unified income tax rate of 25% for both domestic and foreign invested enterprises. New technology enterprises will enjoy a favorable tax rate of 15%, but the qualifying criteria for a new technology enterprise under the Corporate Income Tax Law have not been released yet. The previous income tax laws and rules, which stipulated income tax rates for domestic and foreign invested enterprises at different rates, expired upon the effectiveness of the Corporate Income Tax Law.
The Corporate Income Tax Law provides a five-year transitional period for those entities established before March 16, 2007, which enjoyed a favorable income tax rate of less than 25% under the previous income tax laws and rules, to gradually change their rates to 25%. In addition, the Corporate Income Tax Law provides grandfather treatment for companies qualified as new technology enterprises under the previous income tax laws and rules and established before March 16, 2007 if they continue in the period after January 1, 2008 to meet the criteria for new technology enterprises under the previous income tax laws and rules. The grandfather provision allows these enterprises to continue to enjoy their unexpired tax holiday under the previous income tax laws and rules.
The Corporate Income Tax Law also imposes a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China, which were exempted under the previous income tax laws and rules. A lower withholding tax rate will be applied if there is a tax treaty arrangement between mainland China and the jurisdiction of the foreign holding company. Holding companies in Hong Kong, for example, will be subject to a 5% rate. Most of our China-based subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age are invested by immediate foreign holding companies in Hong Kong, except for Sogou Technology. All of these foreign invested enterprises will be subject to the withholding tax on January 1, 2008. Since we intend to reinvest our earnings to further expand our businesses in mainland China, our foreign invested enterprises do not intend to declare dividends to their immediate foreign holding companies in the foreseeable future. Accordingly, as of December 31, 2007, we have not recorded any withholding tax on the retained earnings of our foreign invested enterprises in China.
Currently, there are divergent views on how the Corporate Income Tax Law will be implemented. The Company's ultimate applicable effective tax rate in 2008 and beyond will depend on many factors, including but not limited to whether certain of its legal entities will obtain an approval of their new technology enterprise status under the Corporate Income Tax Law, whether they could continue to enjoy the unexpired tax holidays and how the withholding tax on dividends will be applied. If any of Sohu Era, Sohu Media, Sogou Technology, AmazGame Age, Sohu Internet, Sogou Information and Gamease Age cannot obtain an approval on their new technology enterprise status under the Corporate Income Tax Law and/or cannot continue to enjoy the unexpired tax holidays or if the withholding tax on dividends is applied in a manner different from our understanding, our effective tax rate will be increased significantly. Also, under the Corporate Income Tax Law, the tax bureau may disallow us to deduct certain types of expenses.
The Corporate Income Tax Law emphasizes the requirement of an arm’s length basis for transfer pricing arrangements between related parties. Also, it requires enterprises with related party transactions to prepare transfer pricing documentation which includes the basis for determining pricing, the computation methodology and detailed explanations. Under a tax inspection by tax authorities, if our transfer pricing arrangements between the China-based subsidiaries and VIEs are judged as tax avoidance, or related documentation does not meet the requirements of the Corporate Income Tax Law, our China-based subsidiaries and VIEs may be subject to tax adjustments and late payment interest.
Our subsidiaries and VIEs in China are subject to restrictions on paying dividends or making other payments to our overseas entities.
We are a holding company and do not have any assets or conduct any business operations in China other than our investments in our Chinese subsidiaries and VIEs. As a result, we depend on dividend payments from our subsidiaries in China after they receive payments from our VIEs under various services and other arrangements. It is possible that our Chinese subsidiaries will not continue to receive the payments in accordance with our contracts with our VIEs. To the extent that the VIEs have undistributed after tax net income, we must pay tax on behalf of our employees who hold interests in the VIEs when the VIEs distribute dividends in the future. The current individual income tax rate is 20%. In addition, under PRC law, our China-based subsidiaries are only allowed to pay dividends to us out of their accumulated profits, if any, as determined in accordance with PRC accounting standards and regulations. The Corporate Income Tax Law imposes a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China, which were exempted under the previous income tax laws and rules. A lower withholding tax rate will be applied if there is a tax treaty arrangement between mainland China and the jurisdiction of the foreign holding company. Holding companies in Hong Kong, for example, will be subject to a 5% rate. Most of our China-based subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age are invested by immediate foreign holding companies in Hong Kong, except for Sogou Technology. All of these foreign invested enterprises will be subject to the withholding tax on January 1, 2008. Moreover, our Chinese subsidiaries are required to set aside at least 10% of their respective accumulated profits, up to 50% of their registered capital, to fund certain mandated reserve funds that are not payable or distributable as cash dividends.
The PRC government also imposes controls on the convertibility of RMB into foreign currencies and, in certain cases, the remittance of currencies out of China. We may experience difficulties in completing the administrative procedures necessary to obtain and remit foreign currencies. If we or any of our subsidiaries are unable to receive all of the revenues from our operations through these contractual or dividend arrangements, we may be unable to effectively finance our operations or pay dividends on our shares.
Restrictions on currency exchange may limit our ability to utilize our revenues effectively.
Substantially all of our revenues and operating expenses are denominated in RMB. The RMB is currently freely convertible under the “current account”, which includes dividends, trade and service related foreign exchange transactions, but not under the “capital account”, which includes foreign direct investment.
Currently, our China-based subsidiaries may purchase foreign exchange for settlement of “current account transactions”, including payment of dividends, without the approval of the State Administration for Foreign Exchange (or SAFE). Our China-based subsidiaries may also retain foreign exchange in its current account (subject to a ceiling approved by the SAFE) to satisfy foreign exchange liabilities or to pay dividends. However, the relevant PRC governmental authorities may limit or eliminate our ability to purchase and retain foreign currencies in the future.
Since a significant amount of our future revenues will be in the form of RMB, the existing and any future restrictions on currency exchange may limit our ability to utilize revenue generated in RMB to fund our business activities outside China, if any, or expenditures denominated in foreign currencies.
Foreign exchange transactions under the capital account are still subject to limitations and require approvals from the SAFE. This could affect our China-based subsidiaries’ ability to obtain foreign exchange through debt or equity financing, including by means of loans or capital contributions from us.
We may suffer currency exchange losses if the RMB depreciates relative to the US Dollar.
Our reporting currency is the US Dollar. However, substantially all of our revenues are denominated in RMB. In July 2005, China reformed its exchange rate regime by establishing a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. The RMB is no longer pegged to the US dollar and the exchange rate will have some flexibility. Hence, considering the floating exchange rate regime, if the RMB depreciates relative to the US Dollar, our revenues as expressed in our US Dollar financial statements will decline in value. On May 19, 2007, the People’s Bank of China announced a policy to expand the maximum daily floating range of RMB trading prices against the U.S. dollar in the inter-bank spot foreign exchange market from 0.3% to 0.5%. While the international reactions to the RMB revaluation and widening of the RMB’s daily trading band have generally been positive, with the increased floating range of the RMB’s value against foreign currencies, the RMB may appreciate or depreciate significantly in value against the U.S. dollar or other foreign currencies in the long term, depending on the fluctuation of the basket of currencies against which it is currently valued. In addition, there are very limited hedging transactions available in China to reduce our exposure to exchange rate fluctuations. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedges may be limited and we may not be able to successfully hedge our exposure, if at all. In addition, our currency exchange losses may be magnified by PRC exchange control regulations that restrict our ability to convert RMB into US Dollars.
The market price of our common stock has been and will likely continue to be volatile. The price of our common stock may fluctuate significantly, which may make it difficult for stockholders to sell shares of our common stock when desired or at attractive prices.
The market price of our common stock has been volatile and is likely to continue to be so. The initial public offering price of our common stock in July 2000 was $13.00 per share. The trading price of our common stock subsequently dropped to a low of $0.52 per share on April 9, 2001. During 2006, the trading price of our common stock ranged from a low of $18.20 per share to a high of $29.43 per share. During 2007, the trading price of our common stock ranged from a low of $20.94 per share to a high of $64.83 per share. On February 27, 2007, the closing price of our common stock was $45.25 per share.
In addition, the Nasdaq Stock Market’s National Market has from time to time experienced significant price and volume fluctuations that have affected the market prices for the securities of technology companies, and particularly Internet-related companies.
The price for our common stock may fluctuate in response to a number of events and factors, such as quarterly variations in operating results, announcements of technological innovations or new products and media properties by us or our competitors, changes in financial estimates and recommendations by securities analysts, the operating and stock price performance of other companies that investors may deem comparable to us, and news reports relating to trends in our markets or general economic conditions. Additionally, volatility or a lack of positive performance in our stock price may adversely affect our ability to retain key employees, all of whom have been granted stock options or other stock awards.
We are controlled by a small group of our existing stockholders, whose interests may differ from other stockholders.
Our Chief Executive Officer, Dr. Zhang, beneficially owns approximately 23% of the outstanding shares of our common stock and is our largest stockholder. Our Chief Executive Officer, together with our other executive officers and members of our Board of Directors, beneficially own approximately 26% of the outstanding shares of our common stock. Accordingly these stockholders acting together will have significant influence in determining the outcome of any corporate transaction or other matter submitted to the stockholders for approval, including mergers, consolidations, the sale of all or substantially all of our assets, election of directors and other significant corporate actions. They will also have significant influence in preventing or causing a change in control. In addition, without the consent of these stockholders, we may be prevented from entering into transactions that could be beneficial to us. The interests of these stockholders may differ from the interests of the other stockholders.
Anti-takeover provisions of the Delaware General Corporation Law, our certificate of incorporation and Sohu’s Stockholder Rights Plan could delay or deter a change in control.
Some provisions of our certificate of incorporation and by-laws, as well as various provisions of the Delaware General Corporation Law, may make it more difficult to acquire our company or effect a change in control of our company, even if an acquisition or change in control would be in the interest of our stockholders or if an acquisition or change in control would provide our stockholders with a premium for their shares over then current market prices. For example, our certificate of incorporation provides for the division of the board of directors into two classes with staggered two-year terms and provides that stockholders have no right to take action by written consent and may not call special meetings of stockholders, each of which may make it more difficult for a third party to gain control of our board in connection with, or obtain any necessary stockholder approval for, a proposed acquisition or change in control.
In addition, we have adopted a stockholder rights plan under the terms of which, in general, if a person or group acquires more than 20% of the outstanding shares of common stock, all other Sohu stockholders would have the right to purchase securities from Sohu at a substantial discount to those securities’ fair market value, thus causing substantial dilution to the holdings of the person or group which acquires more than 20%. The stockholder rights plan may inhibit a change in control and, therefore, could adversely affect the stockholders’ ability to realize a premium over the then-prevailing market price for the common stock in connection with such a transaction.
The power of our Board of Directors to designate and issue shares of preferred stock could have an adverse effect on holders of our common stock.
Our certificate of incorporation authorizes our board of directors to designate and issue one or more series of preferred stock, having rights and preferences as the board may determine, and any such designations and issuances could have an adverse effect on the rights of holders of common stock.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Our principal executive offices are located in the Sohu.com Internet Plaza in the Zhongguancun area of Beijing, China. On January 27, 2007 we entered into agreements with Vision Huaqing (Beijing) Development Co. Ltd., our then landlord, to purchase the premises we then occupied, at a purchase price of approximately $35.3 million. The premises consist of approximately 18,265 square meters. The actual transfer of title to the premises from Vision Huaqing (Beijing) Development Co. Ltd. to us was effective, and approval from the Beijing Municipal Bureau of State Land and Resources and Beijing Municipal Construction Committee was obtained, on February 14, 2007. We also lease sales and marketing office space in Shanghai, Guangzhou, Fuzhou, Wuhan, Chengdu, Tianjin, Chongqing, Hangzhou, Nanjing, Shijiazhuang, Shenyang and Hong Kong.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
There are no material legal proceedings pending or, to our knowledge, threatened against us. From time to time we become subject to legal proceedings and claims in the ordinary course of our business, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights, and a variety of claims arising in connection with our email, message boards and other communications and community features, such as claims alleging defamation or invasion of privacy. However, such legal proceedings or claims, even if not meritorious, could result in the expenditure of significant financial and management resources.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our security holders during the last quarter of the year ended December 31, 2007.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON STOCK, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock is traded on the Nasdaq National Market, under the symbol “SOHU”. Public trading in our common stock commenced on July 12, 2000. The following table sets forth the high and low sale prices of our common stock as reported by the Nasdaq Stock Market for the quarters indicated.
The closing price of our common stock on February 27, 2008 as reported by the Nasdaq National Market was $45.25.
Holders
As of February 8, 2008, there were approximately 29 holders of record of our common stock. As of February 8, 2008, the latest practicable date, there were approximately 27,350 beneficial holders of our common stock.
Dividends
Since our inception, we have not declared or paid dividends on our common stock and we do not expect to pay any dividends in the foreseeable future.
Securities Authorized for Issuance under Equity Compensation Plans
Additional information required under this item is incorporated herein by reference to Item 12 of this Annual Report on Form 10-K under the heading of “Equity Compensation Plan Information.”
Recent Sales of Unregistered Securities
None.
Issuer Purchases of Equity Securities
For the quarter ended December 31, 2007, we did not repurchase any equity securities.
Report of Offering of Securities and Use of Proceeds Therefrom
Initial Public Offering of our Common Stock
On July 17, 2000, we completed an underwritten initial public offering of our common stock pursuant to a Registration Statement on Form S-1 (SEC file No. 333-96137), which became effective on July 10, 2000. Our net proceeds, after deduction of the underwriting discount of $4.2 million and offering expenses of $3.2 million, were approximately $52.4 million. None of the expense payments were made to the underwriters, to any of our directors, officers or affiliates or to any persons owning 10% or more of any class of our equity securities.
Through December 31, 2007, we had used $8.2 million of the net proceeds from the offering for operating activities, purchases of fixed assets, funding for certain equity investments and strategic acquisitions of complementary businesses. The remaining net proceeds from the offering have been invested in cash and cash equivalents, and marketable debt securities. The use of the proceeds from the offering does not represent a material change in the use of proceeds described in the prospectus contained in the Registration Statement on Form S-1 described above.
In October 2005, the board of directors approved our repurchase of outstanding shares of our common stock from the open market, on an opportunistic basis, up to $15 million. During the year ended December 31, 2006, we repurchased 690,580 shares at an average price of $21.72, utilizing the $15 million available under the program. In addition, on July 25, 2006, the board of directors approved an additional $15 million stock repurchase program. As of December 31, 2007, the Company had not repurchased any common stock under this new program.
PERFORMANCE GRAPH
The following graph compares the cumulative total stockholder return for Sohu, the Nasdaq Stock Market (U.S. companies) Index (or the Nasdaq Market Index) and the Hemscott Group Index for Internet Information Providers (or Hemscott Group Index). The graph covers the period from December 31, 2002 to December 31, 2007. The graph assumes that $100 was invested on December 31, 2002 in our common stock, the Nasdaq Market Index and the Hemscott Group Index, and the reinvestment of any dividends. The stock price performance on the following graph is not necessarily indicative of future stock price performance.
The Stock Performance Graph is not “soliciting material”, is not deemed filed with the Securities and Exchange Commission and is not deemed to be incorporated by reference by any general statement incorporating by reference this annual report on Form 10-K into any filing of the Company under the Securities Act of 1933, or any filing under the Securities Exchange Act of 1934, except to the extent that we specifically request that the information be treated as soliciting material or specifically incorporate this information by reference into any such filing, and will not otherwise be deemed incorporated by reference into any other filing under the Securities Act or the Securities Exchange Act, except to the extent that we specifically incorporate it by reference.
Information used on the graphs was obtained from Ipreo, LLC (Hemscott, Inc.), a source believed to be reliable, but we are not responsible for any errors or omissions in such information.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, the consolidated financial statements and notes thereto and the other information contained in this Form 10-K.
In previous years, we had included all of our Website operating costs in cost of revenues of brand advertising. In 2005, in order to improve the measurement of performance of each segment, we began allocating Website operating costs to the cost of revenues of each segment based on actual usage. Accordingly, we reclassified the cost of revenues amongst each segment for 2004 and 2003 presented to conform with current year classification. In general, the impact of this re-allocation has not materially affected the trend of gross profit of each segment.
On June 20, 2006, we discontinued our e-commerce platform of physical consumer goods, in order to focus on profitable segments. As a result of the discontinuation of this business, the e-commerce business is accounted for as a discontinued operation. Accordingly, our statements of operations separate the discontinued operation for all years presented.
In 2007, we adjusted our reportable segments and have reclassified results of our online game segment from our other operations and reported online game results as a separate segment. Accordingly, we reclassified the revenue and cost of revenue of the online game segment for the years prior to 2007 to conform with the current year classification.
Prior to 2007, most of the costs and expenses of the game department were related to product development and research. Accordingly, we recorded all such costs and expenses in product development expenses in the statements of operations. In 2007, in order to better present operating results and enhance comparability with industry peers, we reclassified expenses in relation to game operations, mainly salary and benefits of game masters, from product development expense to cost of online game revenues. To conform with current period presentations, the relevant amounts for prior periods have been reclassified.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We are a leading online media, search, online game and mobile value-added services company providing comprehensive online products and services to consumers and businesses in China, through our comprehensive matrices of web properties, consisting of the mass portal and leading online media destination www.sohu.com; the interactive search engine www.sogou.com; the leading games information portal www.17173.com; one of the top real estate Websites www.focus.cn; the leading online alumni club www.chinaren.com; a leading online mapping service Website www.go2map.com and the wireless value-added services provider www.goodfeel.com.cn. We offer our user community very broad choices regarding information, entertainment, communication, online game and wireless services. We derive revenue primarily through the sale of brand advertising, sponsored search, online game and wireless services. We also sponsor major events to further enhance our viewership and create a positive branding impact.
We were incorporated in the state of Delaware in August 1996 as Internet Technologies China Incorporated, and launched our original Website, itc.com.cn, in January 1997. During 1997, we developed the Sohu online directory, search engine and related technology infrastructure, and also focused on recruiting personnel, raising capital and aggregating content to attract and retain users. In February 1998, we re-launched our Website under the domain name sohu.com. In September 1999, we re-named our company Sohu.com Inc. Our business operations are conducted primarily through our indirect wholly owned subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age and our VIEs, High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information, 21 East Beijing, Gamease Age and New 21 East.
On May 31, 2005, we completed the acquisition of all of the outstanding capital stock of Go2Map Inc., and all of the registered share capital of Tu Xing Tian Xia, a company incorporated in the PRC which was an affiliate of Go2Map Inc (collectively “Go2Map”). Go2Map is one of the leading online mapping service providers in China. Revenues of $919,000 and $1.2 million, costs and expenses of $3.6 million and $2.8 million for the year ended December 31, 2007 and 2006, respectively.
We incurred significant net losses from our inception in August 1996 through the quarter ended June 30, 2002. These losses were funded with private placements of convertible preferred stock and our initial public offering. As of December 31, 2007, we had retained earnings of $79.4 million. However, we intend to continue spending on content enhancements, research and development, technology, infrastructure, marketing and brand development. As a result, net losses could occur in the future. We anticipate funding such losses in excess of our retained earnings, if any, with cash flows from operating activities and the remaining proceeds from our initial public offering.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 on-going 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 believe accounting for brand advertising and sponsored search revenues, accounting for online game revenues, accounting for wireless revenues and cost of revenues, gross versus net basis of revenue recognition, determination of functional currencies, allowance for doubtful accounts, assessment of impairment for goodwill, intangible assets, fixed assets and other assets, determination of share-based compensation expense, and valuation allowance against deferred tax assets, represent critical accounting policies that reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition
Advertising Revenues
Advertising revenues include revenue from brand advertising and sponsored search services, after deducting agent rebates and applicable business tax. No revenues from advertising-for-advertising barter transactions were recognized.
Brand advertising contracts establish the fixed price and advertising services to be provided. Pursuant to brand advertising contracts, we provide advertisement placements on various Website channels and in different formats, including but not limited to banners,
links, logos, buttons, rich media and content integration. Revenue is recognized ratably over the period the advertising is provided and, as such, we consider the services to have been delivered. We treat all elements of advertising contracts as a single unit of accounting for revenue recognition purposes. Based upon our credit assessments of our customers prior to entering into contracts, we determine if collectibility is reasonably assured. In situations where collectibility is not deemed to be reasonably assured, we recognize revenue upon payment from the customers.
Sponsorship contracts may include services similar to those in our brand advertising contracts, are generally for larger dollar amounts and for a longer period of time, may allow advertisers to sponsor a particular area on our Websites, may include brand affiliation services and/or a larger volume of services, and may require some exclusivity or premiere placements. Sponsorship advertisement revenues are normally recognized on a straight-line basis over the contract period, provided we are meeting our obligations under the contract.
Pursuant to sponsored search contracts, which are normally for relatively small dollar amounts and are with small and medium sized enterprises, sponsored search services mainly include priority placements in our search directory and pay-for-click services consisting of displaying the text-based links of our advertisers on our Websites and our Website Alliance network. We normally provide priority placements services for a fixed fee over the service period of the contracts. Revenues on priority placements are normally recognized on a straight-line basis over the contract period provided we are meeting our obligation under the contract. Pay-for-click services of displaying the text-based links to our advertisers’ Websites are charged on a cost per click basis, so that an advertiser pays us only when a user clicks on the displayed link. The priority of the display of text-based links is based on the bidding price of different advertisers. Revenues from the pay-for-click services are recognized as the users click on the links.
Material differences could result in the amount and timing of our advertising revenue for any period if management made different judgments or utilized different estimates.
Non-Advertising Revenues
Non-advertising revenues include revenues principally from online game and wireless services.
Online game revenues are collected through sale of our prepaid cards, which we sell in both virtual and physical form, to third party distributors and retailers. Prior to December 2006, we operated our MMORPG games under a time-based model. Under this model, the proceeds from sale of prepaid cards from distributors or retailers are deferred when received and revenue is recognized based upon the actual usage of time units by the end users. In December 2006, we changed the revenue model from time-based to item-based. Under the new item-based model, players play a game on a free of charge basis and with the ability to purchase in-game premium features. Proceeds from sale of prepaid cards are deferred when received and revenue is recognized over the estimated lives of the premium features purchased or as the premium features are consumed. While we have adopted the new item-based model for our online games for a relatively short operation history, we considered the average period that players typically play our games and other player behavior patterns to arrive at our best estimates for the lives of these in-game features. However, if different assumptions were used and resulted in a different estimate of the average period, it may impact the timing that we record our revenues.
Wireless revenues are derived from providing SMS, RBT, WAP, MMS and IVR, mainly consisting of news, weather forecast, chatting, entertainment information, ring tones, and logo downloads and various other mobile related products provided to mobile phone users. Wireless service fees are charged on a monthly or per message/download basis. Wireless revenues and cost of revenues are recognized in the month in which the service is performed, provided no significant obligations remain. We rely on mobile network operators in China to bill mobile phone users for wireless service fees. In order to meet ownership requirements under PRC law which restrict or prohibit wholly foreign owned enterprises from providing Internet information and value-added telecommunication services such as wireless, we rely on Sohu Internet and Goodfeel to contract with the mobile network operators. Generally, (i) within 15 to 120 days after the end of each month, Sohu Internet or Goodfeel receives statements from each of the operators confirming the amount of wireless service charges billed to that operator’s mobile phone users and (ii) within 30 to 180 days after delivering monthly statements, each operator remits the wireless service fees, net of its service fees, for the month to Sohu Internet or Goodfeel. In order to recognize revenue and be paid for services provided, we rely on billing confirmations from the mobile network operators as to the actual amount of services they have billed to their mobile customers. We are unable to collect certain wireless services fees from an operator in certain circumstances due to technical issues with the operator’s network. This is referred to as the “failure rate”, which can vary from operator to operator. Recently, the time lag in receiving monthly statements from one of the mobile network operators has increased. At the end of each reporting period, where an operator has not provided Sohu Internet or Goodfeel with the monthly statements for any month confirming the amount of wireless service charges billed to that operator’s mobile phone users for the month, we, using information generated from our own internal system and historical data, make estimates of the failure rate and collectable wireless service fees and accrues revenue accordingly. The quarterly historical differences in our estimated revenue which was recorded in the financial statements compared to the actual revenue have ranged from an underestimation of $538,000 (gross margin underestimate of $286,000) to an overestimation of $340,000 (gross margin overestimate of $171,000) since 2002 when wireless revenues began representing a significant portion of our total revenues. We believe we have the ability to make a reasonable
estimate. However, differences between the actual failure rate and bad debt rate per an operator’s statement and our internal estimates could result in material differences in the amount and timing of our revenue and cost of non-advertising revenue for any period. For the three months ended December 31, 2007, 69.9% of our estimated wireless revenues were confirmed by the monthly statements received from the mobile network operators.
Our management must determine whether to record our wireless revenues using the gross or net method of reporting. Determining whether revenue should be reported gross or net is based on an assessment of various factors, principally whether we are acting as the principal in offering services to the customer or whether we are acting as an agent in the transaction. To the extent we are acting as a principal in a transaction, we report as revenue the payments received on a gross basis, and reports as costs of revenue the amounts attributable to services provided by mobile network operators and other vendors. To the extent we are acting as an agent in a transaction, we report on a net basis reporting as revenue the payments received less commission and other payments to third parties. The determination of whether we are serving as principal or agent in a transaction is judgmental in nature and based on an evaluation of the terms of an arrangement.
Based on our assessment, the majority of our wireless revenues are recorded on a gross basis. We have primary responsibility for fulfillment and acceptability of the wireless services. The content and nature of the wireless services are designed and developed by us (either independently or with third parties) and originate from our Websites, our links located on third parties’ Websites, or one of our dedicated phone numbers. The mobile network operators that we contract with to deliver these services to the end customers are not involved in the design or development of the services that are provided by us. The end customer purchases the wireless content, community access or value-added services, such as news, weather forecast, chatting, entertainment information, ring tones, and logo downloads and various other mobile related products provided to mobile phone users. The end customer receives identical services from us regardless of which mobile network operator is used to deliver the message. In addition, we provide customer services to the end customers directly and we could be requested by the mobile network operators to assume the credit risk if the operators are not able to collect fees from the end customers. We have determined that in addition to the indicators of gross reporting, there are also certain indicators of net reporting, including the fact that the mobile network operators set maximum prices that we can charge and that the mobile network operators also have the right to set requirements and procedures associated with using their platform. However, we have determined that the gross revenue reporting indicators are stronger, because we are the primary obligor, adds value to the products, has inventory risk related to content and products, and has reasonable pricing latitude.
To the extent revenues are recorded gross, any commissions or other payments to third parties are recorded as costs or expenses so that the net amount (gross revenues, less costs and expenses) flows through to operating income. Accordingly, the impact on operating income is the same whether we record the revenue on a gross or net basis.
Functional Currency
Our functional currency is the US Dollar. The functional currency of our subsidiaries and VIEs in China is RMB. An entity’s functional currency is the currency of the primary economic environment in which it operates; normally, that is the currency of the environment in which it primarily generates and expends cash. Management’s judgment is essential in determination of the functional currency by assessing various indicators, such as cash flows, sales price and market, expenses, financing and inter-company transactions and arrangements. Assets and liabilities of the China subsidiaries and VIEs are translated into US Dollar, our reporting currency, at the exchange rate in effect at the balance sheet date. Foreign currency translation adjustments are not included in determining net income for the period but are accumulated in a separate component of consolidated equity on the balance sheet. The accumulated foreign currency translation adjustment as of December 31, 2007 and December 31, 2006 was a gain of $11.9 million and $5.2 million, respectively.
Allowance for Doubtful Accounts Receivable
Our management must make estimates of the collectibility of our accounts receivable. Management specifically analyzes accounts receivable, historical bad debts, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance was $29.1 million, net of allowance for doubtful accounts of $2.1 million as of December 31, 2007. If the financial condition of Sohu’s customers or mobile network operators were to deteriorate, resulting in their inability to make payments, or the mobile network operators requested that we assume additional bad debts as a result of the operators’ inability to collect fees from end customers, additional allowance might be required.
Impairment on Long-Lived Assets
Our long-lived assets include goodwill, intangible assets, fixed assets and other assets. We test goodwill for impairment at the reporting unit level (operating segment) on an annual basis, and between annual tests when an event occurs or circumstances change that could more likely than not reduce the fair value of goodwill below its carrying value. Application of a goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill
to reporting units, and determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates and making other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value for each reporting unit. Any impairment losses recorded in the future could have a material adverse impact on our financial condition and results of operations. As of December 31, 2007, we did not believe that any event or change of circumstances had occurred that would result in material impairment losses in goodwill.
In respect of our intangible assets, which mainly comprise domain names, trademarks, customer lists and computer software purchased from unrelated third parties, we amortize the costs over their expected future economic lives. Fixed assets comprise office buildings, investment properties, computer equipment and hardware, office furniture, vehicles and leasehold improvements, and are depreciated over the estimated useful lives of the assets on a straight-line basis. Other assets mainly include prepaid content fees and rental deposits. We amortize the content fees over the terms of the contracts. Management’s judgment is required in the assessment of the economic lives of intangible assets and useful lives of the fixed assets and other assets. Based on the existence of one or more indicators of impairment, we measure any impairment of intangible assets, fixed assets and other assets based on a projected discounted cash flow method using a discount rate determined by our management which is commensurate with the risk inherent in our business model. An impairment charge would be recorded if we determined that the carrying value of intangible assets, fixed assets or other assets may not be recoverable. Our estimates of future cash flows require significant judgment based on our historical results and anticipated results and are subject to many factors. As of December 31, 2007, we were not aware of any indication of impairment of our intangible assets, fixed assets and other assets.
Share-Based Compensation
Effective from January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (or SFAS 123(R)), which requires all share-based payments to employees and directors, including grants of stock options and restricted stock units, to be recognized in the financial statements based on their grant date fair values.
As of January 1, 2006, we adopted SFAS 123(R) using the modified prospective method. The fair value of the options granted before January 1, 2006 is determined based on the Black-Scholes valuation model, which is consistent with the valuation techniques utilized when we prepared pro forma information under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (or SFAS 123). Restricted stock units are measured based on the fair market values of the underlying stock on the dates of grant. Fair value of the share-based awards is recognized as share-based compensation cost over the requisite service period, net of estimated forfeitures on an accelerated basis under SFAS 123(R).
The determination of the fair value of share-based awards and related share-based compensation expense requires input of subjective assumptions, including but not limited to the valuation model adopted, risk-free interest rates, expected life of the share-based awards, stock price volatility, and expected forfeiture rate. The selection of an appropriate valuation technique or model depends on the substantive characteristics of the instrument being valued. Risk-free interest rates are decided based on the yield to maturity of US government bonds as at respective dates of grant of options. Expected life is the number of years that we estimate, based primarily on the history, using “plain-vanilla” method, that options will be outstanding prior to settlement. Volatility is measured using historical daily price changes of our stock over the respective expected life of the option. Forfeiture rate is estimated based on historical forfeiture pattern and adjusted in accordance with our expectation for the future.
Our input assumptions were based on historical experience, with consideration to developing expectations about the future. The assumptions used in calculating the fair value of share-based awards and related share-based compensation represent management’s best estimations, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change or we utilize different assumptions, our share-based compensation expense could be materially different for any period.
Valuation Allowance against Deferred Tax Assets
We estimate income tax expense in each of the jurisdictions in which we operate for each period presented, including estimating current tax exposure as well as assessing realizable deferred tax assets and deferred tax liabilities.
As of December 31, 2007, the majority of our deferred tax assets are related to net operating losses that would apply to United States income taxes. As substantially all of our income is earned in China, and we do not intend in the foreseeable future to repatriate this income to the United States where it would be taxable, it is more likely than not that deferred tax assets resulting from these net operating losses will not be realized. The remaining deferred tax assets are related to China-based subsidiaries and VIEs, resulting from net operating losses and temporary differences between accounting and tax bases. We have recorded a valuation allowance against our gross deferred tax assets in order to reduce our deferred tax assets to the amount that is more likely than not to be realized. If events were to occur in the future that would allow us to realize more of our deferred tax assets than the presently recorded net
amount, an adjustment would be made to the deferred tax assets that would increase income for the period when those events occurred. If events were to occur in the future that would require us to realize less of our deferred tax assets than the presently recorded net amount, an adjustment would be made to the valuation allowance against deferred tax assets that would decrease income for the period when those events occurred.
Significant management judgment is required in determining income tax expense, and deferred tax assets and liabilities.
RESULTS OF OPERATIONS
Year Ended December 31, 2007 compared to Year Ended December 31, 2006
In order to focus on our core business of online advertising, on June 20, 2006, we discontinued our unprofitable e-commerce business. As a result of the discontinuation of this business, the e-commerce business is accounted for as a discontinued operation. Accordingly, our statements of operations separate the discontinued operation for all periods presented.
Revenues
Total revenues were $188.9 million and $134.2 million for the years ended December 31, 2007 and 2006, respectively.
Advertising Revenues
Advertising revenues are derived principally from brand advertising and sponsored search.
Advertising revenues were $119.2 million and $91.8 million, or 63% and 68% of total revenues for the years ended December 31, 2007 and 2006, respectively. For the year ended December 31, 2007, advertising revenues consisted of revenues from brand advertising of $112.1 million, and revenues from sponsored search of $7.1 million. For the year ended December 31, 2006, advertising revenues consisted of revenues from brand advertising of $79.0 million, and revenues from sponsored search of $12.8 million.
Brand advertising. Brand advertising revenues increased by $33.1 million to $112.1 million for the year ended December 31, 2007 as compared to $79.0 million for the year ended December 31, 2006. The increase of revenues in 2007 was attributable to increase of number of advertisers and increase of price. The increase of $33.1 million from 2006 to 2007 consisted of: (i) a $17.1 million increase from advertisers who advertised with us during the year ended December 31, 2007 but did not advertise on our Websites during the year ended December 31, 2006; (ii) a $37.5 million increase in revenues from the advertisers who advertised with us in 2006 and continued to do so in 2007; and (iii) a $21.5 million decrease in revenues as some of the advertisers who advertised with us during the year ended December 31, 2006 did not advertise on our Websites during the year ended December 31, 2007. We had approximately 1,070 advertisers in 2007 as compared to 850 advertisers in 2006. Sales to our five largest advertisers comprised both 14% of total brand advertising revenues for the years ended December 31, 2007 and 2006, respectively. No single advertiser accounted for more than 10% of total brand advertising revenues for the years ended December 31, 2007 and 2006. Our advertising customers consisted primarily of companies within automobile, real estate, online games, information technology, financial services and fast moving consumer goods industries. The fastest growing sectors for brand advertising were online games, fast moving consumer goods and financial services industries in 2007. As of December 31, 2007 and 2006, we had $1.4 million and $2.2 million of receipts in advance from advertisers, respectively. We have not recorded any revenue from advertising-for-advertising barter transactions.
For the years ended December 31, 2007 and 2006, we recorded brand advertising revenues of approximately $962,000 and $42,000, respectively, from Fujian Tian Qing Digital Co., Ltd. (or Fujian Tian Qing), formerly known as NetDragon Websoft Inc., in connection with its advertisements on our 17173.com Website. Those advertising services are provided pursuant to a three-year advertising framework agreement that expired in November 2006 and has been extended to November 2009. Fujian Tian Qing was the owner of 17173.com Website prior to our acquisition of 17173.com from them.
Sponsored search. Sponsored search services revenue decreased by $5.7 million to $7.1 million for the year ended December 31, 2007 as compared to $12.8 million for the year ended December 31, 2006. Sponsored search services primarily include priority placements in our search directory and pay-for-click services of displaying the text-based links of our advertisers on our Websites and our Website Alliance network. Revenues from pay-for-click services accounted for approximately 32% of the total sponsored search revenues in 2007 as compared to 28% in 2006. The decrease in sponsored search revenues mainly resulted from our efforts to further strengthen our anti-fraudulent click-through mechanism starting from second half of 2006 which resulted in a decrease in average click-through rates. We believe the improved anti-fraudulent click-through mechanism will provide benefits to our sponsored search business in the long run.
Non-advertising Revenues
Non-advertising revenues are derived principally from online game, wireless and other services.
Non-advertising revenues were $69.7 million and $42.5 million, or 37% and 32% of total revenues for the years ended December 31, 2007 and 2006, respectively.
For the year ended December 31, 2007, non-advertising revenues consisted of revenues from online game of $42.1 million, from wireless of $26.3 million and from other services of $1.3 million. For the year ended December 31, 2006, non-advertising revenues consisted of revenues from online game of $8.5 million, from wireless of $32.6 million and from other services of $1.4 million.
Online game. Our online game revenues are mainly derived from two game titles, TLBB and BO. TLBB is our first in-house developed online game launched on May 9, 2007. BO was licensed from a local independent game development studio and launched in October 2004.
For the year ended December 31, 2007, online game revenues increased by $33.6 million to $42.1 million as compared to $8.5 million for the year ended December 31, 2006. This was primarily due to the commercial launch of TLBB in May 2007, with total revenue of $35.2 million in 2007, representing 84% of total online game revenues. As of December 31, 2007, the total registered users of TLBB had reached 23 million. In 2007, peak concurrent users of TLBB had exceeded 500,000.
The following table sets forth revenue derived from TLBB in China and related operating data:
Notes:
* Quarterly APA, or quarterly active paying accounts, is the aggregate number of accounts from which game points are utilized at least once during the quarter.
** Quarterly ARPU, or quarterly revenue per active paying accounts, is our online game net revenues during the quarter divided by the quarterly active paying accounts of TLBB during the quarter; our definition of ARPU may not be comparable to similarly titled measures presented by other online game companies.
The success of TLBB in China has enabled us to license the game in the overseas market. In August 2007, we licensed TLBB to an operator in Vietnam. For the year ended December 31, 2007, we recorded revenues of $345,000 for the license fees and usage-based royalties from this arrangement.
Online game revenues are collected through sale of our prepaid cards, which we sell in both virtual and physical form, to third party distributors and retailers. We account for proceeds from sale of prepaid game cards from distributors or retailers as receipts in advance from distributors in our consolidated balance sheet, prior to their registration to specific game accounts. Once a prepaid game card is registered to a specific game account, we account for related amounts as deferred revenues. As of December 31, 2007, we had receipts in advance from distributors of $6.5 million and deferred revenues of $2.0 million, as compared with $0.7 million and $0.3 million, respectively, as of December 31, 2006.
Wireless. Our wireless revenues include SMS, RBT, WAP, MMS and IVR services. Because of restrictions on foreign companies operating in the PRC telecommunications industry, we have used our VIEs to contract on our behalf with PRC mobile network operators who provide the gateway for sending messages and collect our fees from customers. Our VIEs collect the fees from the operators and we then transfer the fees to our subsidiaries on a periodic basis. There was no material impact in 2007 on our revenues or margins from our reliance on these related party arrangements. Our wireless services include news, weather forecast, chatting, entertainment information, ring tone, and logo downloads and various other related products provided to mobile phone users. Most of our services are charged on a monthly or per message/download basis. For the year ended December 31, 2007, we ordinarily charged monthly fees ranging from approximately $0.065 to $4.037 and per message/download fees ranging from approximately $0.006 to $0.538.
For the year ended December 31, 2007, our wireless revenues decreased by $6.3 million to $26.3 million as compared to $32.6 million for the year ended December 31, 2006, primarily due to decreases of $5.7 million in SMS revenues and $4.6 million in WAP revenues and MMS revenues. This decrease was partially offset by an increase of $4.0 million in RBT revenues and IVR revenues. The decrease in SMS revenues was primarily due to the ongoing negative impact of policies such as double confirmation, billing reminders and details of promotion adopted by SPs issued by mobile network operators starting from July 2006. The decrease in WAP revenues was primarily due to the continuing negative impact of operational policy changes, which include limitations on promotion activities for WAP products and the sending of fee reminders to WAP service users, implemented by a mobile network operator in late 2006. The increase in RBT and IVR revenue in 2007 was because of our continued market development effort and product diversification.
Others. Our other services mainly consist of office space rental income, sales of software to third parties, provision of applications service provider (or ASP) services and construction of websites. For the years ended December 31, 2007 and 2006, revenues for other services were $1.3 million and $1.4 million, respectively.
COSTS AND EXPENSES
Prior to 2007, most of the costs and expenses of the game department were related to product development and research. Accordingly, we recorded all such costs and expenses in product development expenses in the statements of operations. In 2007, in order to better present operating results and to enhance comparability with industry peers, we reclassify expenses in relation to game operations, mainly salary and benefits of game masters, from product development expenses to cost of online game revenues. To conform with current period presentations, the relevant amounts for prior periods have been reclassified. Such reclassification amounted to $1.3 million for the year ended December 31, 2006.
Cost of Revenues
Total cost of revenues was $64.8 million and $48.4 million for the years ended December 31, 2007 and 2006, respectively.
Cost of Advertising Revenues
Cost of advertising revenues increased by $15.9 million to $44.4 million for the year ended December 31, 2007 as compared to $28.5 million for the year ended December 31, 2006.
Brand advertising. Cost of brand advertising revenues includes personnel costs and personnel overhead relating to our editorial center, content purchases, payments to our business partners, relevant depreciation of servers and computer equipment and bandwidth leasing costs. Cost of brand advertising revenues was $38.7 million and $23.2 million for the years ended December 31, 2007 and 2006, respectively. The increase of $15.5 million consisted of a $4.7 million increase in content purchases, a $3.9 million increase in personnel expense, a $2.6 million increase in payments to our business partners, a $2.1 million increase in bandwidth leasing cost to our expanded business, a $1.4 million increase in depreciation expense and a $0.8 million increase in other costs. Our brand advertising gross margin for the years ended December 31, 2007 and 2006 was 65% and 71%, respectively. The decrease was mainly because of increased spending on content purchases, increase in headcount, bandwidth leasing costs and server depreciation costs.
Sponsored search. Cost of sponsored search revenues consists primarily of relevant depreciation of servers and computer equipment, bandwidth leasing costs, payments to our Website Alliance, personnel costs and data collection cost. Cost of sponsored search revenues was $5.6 million for the year ended December 31, 2007 as compared to $5.2 million for the year ended December 31, 2006. The increase in cost of sponsored search revenues resulted from an increase of $1.0 million in relevant depreciation and bandwidth leasing costs, which was offset by a $580,000 decrease in payment to Website alliances. Our sponsored search gross margin for the years ended December 31, 2007 and 2006 was 21% and 59%, respectively. The decrease was mainly due to lower revenue and higher server depreciation and bandwidth leasing costs in relation to the launch of Sogou 3.0 in late 2006.
Cost of Non-advertising Revenues
Cost of non-advertising revenues was $20.4 million and $19.9 million for the years ended December 31, 2007 and 2006, respectively.
Online game. Cost of online game revenues primarily consists of personnel costs relating to the operation of the games, bandwidth leasing costs, revenue sharing with the game developer of BO and depreciation of servers and computer equipment. Cost of online game revenues was $7.1 million for the year ended December 31, 2007 as compared to $3.9 million for the year ended December 31, 2006. The increase in cost of online game revenues was mainly due to increased server depreciation and bandwidth leasing costs due to the launch of TLBB, and increase of personnel costs relating to operation of TLBB. Our online game gross margins were 83% for the year ended December 31, 2007 as compared to 54% for the year ended December 31, 2006. The increase primarily represents contribution from TLBB.
Wireless. Cost of wireless revenues mainly consists of collection and wireless transmission charges paid to mobile network operators, expenses related to complaints based on allegations of breaches of certain provisions of our agreements with mobile network operators, fees or royalties paid to third party providers for promotion services and content associated with our wireless services, payments to third party wireless service alliances, relevant depreciation of servers and computer equipment and bandwidth leasing costs. Cost of wireless revenues decreased by $3.1 million to $12.3 million for the year ended December 31, 2007, as compared to $15.4 million for the year ended December 31, 2006. The decrease in cost of wireless revenues resulted from a decrease of $5.2
million in collection charges, transmission charges and expenses related to penalties paid to mobile network operators; the decrease was partially offset by an increase of $2.1 million paid to third party wireless service alliances and content or service providers. The collection and transmission charges vary between mobile network operators and include a gateway fee of $0.003 to $0.027 per message, depending on the volume of the monthly total wireless messages, and a collection fee of 15% to 60% of total fees collected by mobile network operators from mobile phone users (with the residual paid to us) in the year of 2007. Our wireless gross margins were both 53% for the years ended December 31, 2007 and 2006.
Others. Cost of revenues for other services, was $939,000 and $570,000 for the years ended December 31, 2007 and 2006, respectively. Cost of revenues for other services mainly consists of personnel and other expenses in connection with sales of software, provision of ASP services and construction of websites.
Product Development Expenses
Product development expenses increased by $7.7 million to $25.4 million for the year ended December 31, 2007, as compared to $17.7 million for the year ended December 31, 2006. The increase was primarily due to a $4.9 million increase in personnel expenses resulting from an increase in headcount, salaries and bonuses, a $2.2 million increase in license fee, and a $1.0 million increase in share-based compensation expense under SFAS 123(R), which was offset by a $400,000 decrease in other expenses.
Sales and Marketing Expenses
Sales and marketing expenses increased by $19.0 million to $47.5 million for the year ended December 31, 2007, as compared to $28.5 million for the year ended December 31, 2006. The increase primarily consisted of a $13.7 million increase in advertising and promotion expenses, which included the relevant expenses associated with our exclusive Olympic sponsorship in the Internet Content Services category, investment in corporate branding, marketing expenses for Sohu 3.0 and TLBB, a $4.0 million increase in personnel expenses resulting from an increase in headcount, salaries and sales commission, and a $1.3 million increase in other expenses.
General and Administrative Expenses
General and administrative expenses increased by $4.3 million to $17.4 million for the year ended December 31, 2007, as compared to $13.1 million for the year ended December 31, 2006. The increase was primarily due to a $1.7 million increase in personnel expenses, a $1.0 million increase in professional fee, a $900,000 increase in share-based compensation expense under SFAS 123(R), and a $700,000 increase in other expenses.
Amortization of Intangible Assets
Amortization of intangible assets was $1.1 million and $2.0 million for the years ended December 31, 2007 and 2006, respectively, which were mainly related to the acquisitions of the 17173.com, Focus.cn, Goodfeel and Go2Map.
Operating Profit
As a result of the foregoing, our operating profit increased by $8.1 million to $32.7 million for the year ended December 31, 2007, as compared to $24.6 million for the year ended December 31, 2006. The operating profit for the years ended December 31, 2007 and 2006 included $8.8 million and $6.9 million, respectively, for share-based compensation expense recorded under SFAS 123(R).
Other Income
For the year ended December 31, 2007, other income of $887,000 mainly consisted of $561,000 gain from disposal of interest in an associate. In addition, we have also recorded approximately $503,000 of certain tax refund. This was offset by the amortization of $248,000 of the offering costs of our zero coupon convertible senior notes issued in July 2003. For the year ended December 31, 2006, other income of $477,000 mainly consisted of $793,000 of gains from early redemption of zero coupon convertible senior notes with face value of $15.0 million and our share of profits of $151,000 from our investment in an associate. This was offset by the amortization of $537,000 of the offering costs of our zero coupon convertible senior notes issued in July 2003.
Interest Income
Interest income includes net interest income and foreign currency exchange gains. For the year ended December 31, 2007, interest income was $2.8 million as compared to $3.2 million for the year ended December 31, 2006. The decrease was mainly due to the repayment of our convertible notes of $58.5 million in July, which decreased the average cash balance for the year.
Income Tax Expense
For the year ended December 31, 2007, income tax expense was $1.5 million as compared to $1.6 million for the year ended December 31, 2006.
Most of our income is earned by our China-based subsidiaries and VIEs. Prior to January 1, 2008, our subsidiaries in China were governed by the Income Tax Law of the People’s Republic of China concerning Foreign Investment Enterprises and Foreign Enterprises and local income tax laws (the previous income tax laws and rules). Pursuant to the previous income tax laws and rules, wholly-owned foreign enterprises were subject to tax at a statutory rate of 33% (30% state income tax plus 3% local income tax), or 15% for certain technology enterprises, on PRC taxable income. Our China-based subsidiaries and VIEs, Sohu Era, Sohu Media, Sogou Technology, AmazGame Age, Sohu Internet, Sogou Information and Gamease Age, enjoyed tax benefits which were available to new technology enterprises beginning with their first year of operations. Under the previous income tax laws and rules, new technology enterprises could enjoy a favorable tax rate of 15% and were exempted from income tax for three years beginning with their first year of operations, and were entitled to a 50% tax reduction to 7.5% for the subsequent three years and 15% thereafter. For the year ended December 31, 2007, Sohu Era and Sohu Internet were subject to 7.5%, while Sohu Media, Sogou Technology, AmazGame Age, Sogou Information and Gamease Age, were exempted from income tax.
In March 2007, the Chinese government enacted the Corporate Income Tax Law, and promulgated related regulations, which were effective January 1, 2008. The Corporate Income Tax Law, among other things, imposes a unified income tax rate of 25% for both domestic and foreign invested enterprises. New technology enterprises will still enjoy a favorable tax rate of 15%, but the qualifying criteria for a new technology enterprise under the Corporate Income Tax Law have not been released yet. The previous income tax laws and rules, which stipulated income tax rates for domestic and foreign invested enterprises at different rates, expired upon the effectiveness of the Corporate Income Tax Law.
The Corporate Income Tax Law provides a five-year transitional period for those entities established before March 16, 2007, which enjoyed a favorable income tax rate of less than 25% under the previous income tax laws and rules, to gradually change their rates to 25%. In addition, the Corporate Income Tax Law provides grandfather treatment for companies qualified as new technology enterprises under the previous income tax laws and rules and established before March 16, 2007 if they continue in the period after January 1, 2008 to meet the criteria for new technology enterprises under the previous income tax laws and rules. The grandfather provision allows these enterprises to continue to enjoy their unexpired tax holiday under the previous income tax laws and rules.
The Corporate Income Tax Law also imposes a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China, which were exempted under the previous income tax laws and rules. A lower withholding tax rate will be applied if there is a tax treaty arrangement between mainland China and the jurisdiction of the foreign holding company. Holding companies in Hong Kong, for example, will be subject to a 5% rate. Most of our China-based subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age are invested by immediate foreign holding companies in Hong Kong, except for Sogou Technology. All of these foreign invested enterprises will be subject to the withholding tax on January 1, 2008. Since we intend to reinvest our earnings to further expand our businesses in mainland China, our foreign invested enterprises do not intend to declare dividends to their immediate foreign holding companies in the foreseeable future. Accordingly, as of December 31, 2007, we have not recorded any withholding tax on the retained earnings of our foreign invested enterprises in China.
Currently, there are divergent views on how the Corporate Income Tax Law will be implemented. The Company’s ultimate applicable effective tax rate in 2008 and beyond will depend on many factors, including but not limited to whether certain of its legal entities will obtain an approval of their new technology enterprise status under the Corporate Income Tax Law, whether they can continue to enjoy the unexpired tax holidays and how the withholding tax on dividends will be applied. If any of Sohu Era, Sohu Media, Sogou Technology, AmazGame Age, Sohu Internet, Sogou Information and Gamease Age cannot obtain an approval on their new technology enterprise status under the Corporate Income Tax Law and/or cannot continue to enjoy the unexpired tax holidays or if the withholding tax on dividends is applied in a manner different from our understanding, our effective tax rate will be increased significantly.
Income earned in the United States, where Sohu.com Inc. is incorporated, is subject to taxation at 34% or 35%. For the foreseeable future, we anticipate the major source of income earned in the United States and subject to United States taxation to be interest income. If dividends are paid by our China or other non-U.S. subsidiaries to Sohu.com Inc., the dividends would be taxed at Sohu.com Inc.’s rate of taxation, which is 34% or 35% (as reduced by any applicable “deemed-paid” foreign tax credits for foreign income taxes paid by such subsidiaries). For the foreseeable future, we do not intend for the China or other non-U.S. subsidiaries to pay dividends to Sohu.com Inc.
Minority Interests
On October 31, 2006, we completed the acquisition of a 70% interest in 21 East HK and 21 East Beijing (collectively “21 East”), an entertainment company. The acquisition had been accounted for as a purchase business combination and the results of operations from the acquisition date have been included in our consolidated financial statements, resulting in minority interests of $47,000 and $7,000 for the years ended December 31, 2007 and 2006, respectively.
Net Income from Continuing Operations
For the year ended December 31, 2007, income from continuing operations was $35.0 million, as compared to $26.7 million for the year ended December 31, 2006.
Loss from Discontinued E-commerce Operations
On June 20, 2006, we discontinued our e-commerce business. For the year ended December 31, 2007, loss from discontinued e-commerce operations was $20,000, as compared to $841,000 for the year ended December 31, 2006.
Net Income
As a result of the foregoing, we had net income of $34.9 million for the year ended December 31, 2007, as compared to net income of $25.9 million for the year ended December 31, 2006. The net income for the years ended December 31, 2007 and 2006 included $8.8 million and $6.9 million of share-based compensation expense recorded under SFAS 123(R).
Year Ended December 31, 2006 compared to Year Ended December 31, 2005
In order to focus on our core business of online advertising, on June 20, 2006 we discontinued our unprofitable e-commerce business. As a result of the discontinuation of this business, the e-commerce business is accounted for as a discontinued operation. Accordingly, our statements of operations separate the discontinued operation for all periods presented.
Revenues
Total revenues were $134.2 million and $104.5 million for the years ended December 31, 2006 and 2005, respectively.
Advertising Revenues
Advertising revenues are derived principally from brand advertising and sponsored search.
Advertising revenues were $91.8 million and $70.9 million, or both 68% of total revenues for the years ended December 31, 2006 and 2005, respectively. For the year ended December 31, 2006, advertising revenues consisted of revenues from brand advertising of $79.0 million, and revenues from sponsored search of $12.8 million. For the year ended December 31, 2005, advertising revenues consisted of revenues from brand advertising of $58.5 million, and revenues from sponsored search of $12.4 million.
Brand advertising. Brand advertising revenues increased by $20.5 million to $79.0 million for the year ended December 31, 2006 as compared to $58.5 million for the year ended December 31, 2005. The increase in revenues in 2006 was attributable to an increase of the number of advertisers and an increase in prices. The increase of $20.5 million from 2005 to 2006 consisted of: (i) a $15.2 million increase from advertisers who advertised with us during the year ended December 31, 2006 but did not advertise on our Websites during the year ended December 31, 2005; (ii) a $17.9 million increase in revenues from advertisers who advertised with us in 2005 and continued to do so in 2006; and (iii) a $12.6 million decrease in revenues as some of the advertisers who advertised with us during the year ended December 31, 2005 did not advertise on our Websites during the year ended December 31, 2006. We had approximately 850 advertisers in 2006 as compared to 800 advertisers in 2005. Sales to our five largest advertisers constituted 14% and 17% of total brand advertising revenues for the years ended December 31, 2006 and 2005, respectively. No single advertiser accounted for more than 10% of total brand advertising revenues for the years ended December 31, 2006 and 2005. Our advertising customers consisted primarily of companies within the automobile, real estate, information technology, online games, financial services and telecommunication industries. The fastest growing sectors for brand advertising in 2006 were fast moving consumer goods and financial services industries. As of December 31, 2006 and 2005, we had $2.2 million and $1.5 million of receipts in advance from advertisers, respectively. We have not recorded any revenue from advertising-for-advertising barter transactions.
For the years ended December 31, 2006 and 2005, we recorded brand advertising revenues of approximately $42,000 and $626,000, respectively, from Fujian Tian Qing, formerly known as NetDragon Websoft Inc., in connection with its advertisements on our 17173.com Website. Those advertising services were provided pursuant to a three-year advertising framework agreement which expired in November 2006 and has been extended to November 2009. Fujian Tian Qing was the owner of 17173.com Website prior to our acquisition of 17173.com from them.
Sponsored search. Sponsored search services revenue increased by $0.4 million to $12.8 million for the year ended December 31, 2006 as compared to $12.4 million for the year ended December 31, 2005. Sponsored search services primarily include priority placements in our search directory and listing in our classified advertisement section, in addition to pay-for-click services consisting of displaying the text-based links of our advertisers on our Websites and our Website Alliance network. Revenues from pay-for-click services amounted to $3.6 million, accounting for approximately 28% of the total sponsored search revenues in 2006 as compared to 25% in 2005. The increase in sponsored search revenues mainly resulted from an increase in the number of sponsored links and traffic in 2006.
Non-advertising Revenues
Non-advertising revenues are derived principally from online game, wireless and other services.
Non-advertising revenues were $42.5 million and $33.7 million, or both 32% of total revenues for the years ended December 31, 2006 and 2005.
For the year ended December 31, 2006, non-advertising revenues consisted of revenues from online game of $8.5 million, from wireless of $32.6 million and from other services of $1.4 million. For the year ended December 31, 2005, non-advertising revenues consisted of revenues from online game of $5.8 million, from wireless of $26.3 million and from other services of $1.5 million.
Online game. Prior to 2007, we operated two licensed online games, KO and BO. KO was licensed from a Korean game development company and was terminated in November 2006 when the license expired. BO was licensed from a local independent game development studio and launched in October 2004.
For the year ended December 31, 2006, online game revenues increased by $2.7 million to $8.5 million as compared to $5.8 million for the year ended December 31, 2005. The $8.5 million included $380,000 of revenue recognized upon the forfeiture of expired game points.
Wireless. Our wireless revenues include SMS, RBT, WAP, MMS and IVR services. Because of restrictions on foreign companies operating in the PRC telecommunications industry, we have used our VIEs to contract on our behalf with PRC mobile network operators who provide the gateway for sending messages and collect our fees from customers. Our VIEs collect the fees from the operators and we then transfer the fees to our subsidiaries on a periodic basis. There was no material impact on our revenues or margins from our reliance on these related party arrangements. Our wireless services include news, weather forecast, chatting, entertainment information, ring tone, and logo downloads and various other mobile related products provided to mobile phone users. Most of our services are charged on a monthly or per message/download basis. For the year ended December 31, 2006, we ordinarily charged monthly fees ranging from approximately $0.062 to $3.835 and per message/download fee ranging from approximately $0.006 to $0.511.
For the year ended December 31, 2006, our wireless revenues increased by $6.3 million to $32.6 million as compared to $26.3 million for the year ended December 31, 2005, primarily due to increases of $3.2 million in SMS revenues, $1.4 million in WAP revenues, $1.0 million in MMS revenues, and $1.4 million in RBT revenues. This increase was partially offset by a decrease of $0.7 million in IVR revenues. The increase in SMS, WAP, MMS and RBT products in 2006 was because of our continued market development effort and product diversification; the decrease in IVR revenues was primarily due to our limited marketing activities for this product.
In early July 2006, the two major mobile network operators in China, CMCC and Unicom, introduced new policies on wireless value-added services, including double reminders for new monthly subscriptions, billing reminders to existing monthly subscribers and conversion of per message-based SMS subscription to monthly subscriptions. In October 2006, the Ministry of Information Industry (or MII) issued further guidelines regulating the wireless value-added services industry. Based on current trends, it appears that the mobile network operators and regulator may continue to tighten or change operation policies. Our wireless revenue for the second half of year 2006 was negatively impacted by such regulations. In the long run, we believe the industry’s overall development will benefit from those regulations.
Others. Other services consist of sales of software to third parties. For the year ended December 31, 2006, revenues from ASP services were $1.1 million, as compared to $1.0 million for the period from May 31, 2005, the acquisition date of Go2Map, to December 31, 2005.
COSTS AND EXPENSES
Prior to 2007, most of the costs and expenses of the game department were related to product development and research. Accordingly, we recorded all such costs and expenses in product development expenses in the statements of operations. In 2007, in order to better present operating results and to enhance comparability with industry peers, we reclassify expenses in relation to game operations, mainly salary and benefits of game masters, from product development expenses to cost of online game revenues. To conform with current period presentations, the relevant amounts for prior periods have been reclassified. Such reclassification amounted to $1.3 million and $0.9 million for the years ended December 31, 2006 and 2005.
Cost of Revenues
Total cost of revenues was $48.4 million and $33.3 million for the years ended December 31, 2006 and 2005, respectively.
Cost of Advertising Revenues
Cost of advertising revenues increased by $10.8 million to $28.5 million for the year ended December 31, 2006 as compared to $17.7 million for the year ended December 31, 2005.
Brand advertising. Cost of brand advertising revenues includes personnel costs and personnel overhead relating to our editorial center, content purchases, payments to our business partners, relevant depreciation of servers and computer equipment and bandwidth leasing costs. Cost of brand advertising revenues was $23.2 million and $14.6 million for the years ended December 31, 2006 and 2005, respectively. The increase of $8.6 million consisted of a $2.6 million increase in content purchases, a $1.9 million increase in personnel expense, a $1.5 million increase in bandwidth leasing cost to our expanded business, a $1.4 million expense for share-based compensation due to the adoption of SFAS 123(R), a $1.2 million increase in depreciation expense and other costs. Our brand advertising gross margin for the years ended December 31, 2006 and 2005 was 71% and 75%, respectively. Our brand advertising gross margin decreased for the year ended December 31, 2006 mainly because of share-based compensation expense due to the adoption of SFAS 123(R) starting from January 1, 2006, and more spending on content purchases, personnel costs and bandwidth leasing costs.
Sponsored search. Cost of sponsored search revenues consisted primarily of payments to our Website Alliance, data collection cost, personnel costs, relevant depreciation of servers and computer equipment and bandwidth leasing costs. Cost of sponsored search revenues was $5.2 million for the year ended December 31, 2006 as compared to $3.1 million for the year ended December 31, 2005. The increase in cost of sponsored search revenues resulted from an increase of $1.4 million in relevant depreciation and bandwidth leasing costs, an increase of $500,000 in payment to Website alliances and an increase of $200,000 in salary and benefits costs. Our sponsored search gross margin for the years ended December 31, 2006 and 2005 was 59% and 75%, respectively.
Cost of Non-advertising Revenues
Cost of non-advertising revenues was $19.9 million and $15.6 million for the years ended December 31, 2006 and 2005, respectively.
Online game. Cost of online game revenues primarily consists of personnel costs relating to the operation of the games, bandwidth leasing costs, revenue sharing with the game developers of KO and BO and depreciation of servers and computer equipment. Cost of online game revenues was $3.9 million for the year ended December 31, 2006 as compared to $2.7 million for the year ended December 31, 2005. Our online game gross margins were 54% and 53% for the years ended December 31, 2006 and 2005, respectively.
Wireless. Cost of wireless revenues mainly consists of collection and wireless transmission charges paid to mobile network operators, expenses related to complaints based on allegations of breaches of certain provisions of our agreements with mobile network operators, fees or royalties paid to third party content providers for services and content associated with our wireless services, payments to third party wireless service alliances, relevant depreciation of servers and computer equipment and bandwidth leasing costs. Cost of wireless revenues increased by $3.4 million to $15.4 million for the year ended December 31, 2006, as compared to $12.0 million for the year ended December 31, 2005. The increase in cost of wireless revenues resulted from an increase of $2.3 million in collection charges, transmission charges and expenses related to penalties paid to mobile network operators and an increase of $1.1 million paid to third party wireless service alliances and content providers. The collection and transmission charges vary between mobile network operators and include a gateway fee of $0.002 to $0.031 per message, depending on the volume of the monthly total wireless messages, and a collection fee of 15% to 55% of total fees collected by mobile network operators from mobile phone users (with the residual paid to us) in 2006. Our wireless gross margins were 53% and 54% for the years ended December 31, 2006 and 2005, respectively.
Others. Cost of revenues for other services was $570,000 and $914,000 for the years ended December 31, 2006 and 2005, respectively. Following the acquisition of Go2Map, cost of other revenues mainly of personnel and other expenses in connection with sale of software and provision of ASP services. For the year ended December 31, 2006, the cost of sales of software and provision of ASP services was $500,000, as compared to $300,000 for the period from May 31, 2005, the acquisition date of Go2Map, to December 31, 2005.
Product Development Expenses
Product development expenses increased by $4.9 million to $17.7 million for the year ended December 31, 2006, as compared to $12.8 million for the year ended December 31, 2005. The increase was primarily due to a $2.8 million increase in personnel expenses resulting from an increase in headcount and salary increment and $1.9 million of share-based compensation expense under SFAS 123(R), and an increase in other expenses of $200,000.
Sales and Marketing Expenses
Sales and marketing expenses increased by $8.4 million to $28.5 million for the year ended December 31, 2006, as compared to $20.1 million for the year ended December 31, 2005. The increase primarily consisted of a $3.9 million increase in advertising and promotion expenses, which included the relevant expenses associated with our exclusive Olympic sponsorship in the Internet Content Services category and marketing activities of the 2006 FIFA World Cup, $1.6 million for share-based compensation expense under SFAS 123(R), a $1.5 million increase in personnel expenses resulting from an increase in headcount and salary increment, a $811,000 increase in traveling and entertainment expenses, and a $589,000 increase in other expenses.
General and Administrative Expenses
General and administrative expenses increased by $2.9 million to $13.1 million for the year ended December 31, 2006, as compared to $10.2 million for the year ended December 31, 2005. The increase was primarily due to a $1.7 million increase in personnel expenses and $1.4 million in share-based compensation expense under SFAS 123(R), which was offset by a $200,000 decrease in other expenses.
Amortization of Intangible Assets
Amortization of intangible assets was $2.0 million and $1.9 million for the years ended December 31, 2006 and 2005, respectively, which was mainly related to the acquisitions of the 17173.com, Focus.cn, Goodfeel and Go2Map.
Operating Profit
As a result of the foregoing, our operating profit decreased by $1.6 million to $24.6 million for the year ended December 31, 2006, as compared to $26.2 million for the year ended December 31, 2005. The operating profit for the year ended December 31, 2006 included $6.9 million for share-based compensation expense recorded under SFAS 123(R). The operating profit for the year ended December 31, 2005 included $2,000 for share-based compensation expense recorded under APB 25.
Other Income
For the year ended December 31, 2006, other income of $477,000 mainly consisted of $793,000 of gains from early redemption of zero coupon convertible senior notes with face value of $15.0 million and our share of profits of $151,000 from our investment in an associate. This was offset by the amortization of $537,000 of the offering costs of our zero coupon convertible senior notes issued in July 2003. For the year ended December 31, 2005, other income of $2.4 million mainly included gains of $1.2 million arising from early redemption of zero coupon convertible senior notes with face value of $15.22 million. In addition, due to an exemption regarding payment of certain taxes and receipts of tax refunds by our China-based subsidiaries, we also recorded an approximately $1.7 million gain as other income. This was offset by the amortization of $724,000 of the offering costs of our zero coupon convertible senior notes issued in July 2003.
Interest Income
Interest income includes net interest income and foreign currency exchange gains. For the year ended December 31, 2006, interest income was $3.2 million, as compared to $2.5 million for the year ended December 31, 2005. The increase was mainly due to an increase in market interest rates and RMB appreciation.
Income Tax Expense
For the year ended December 31, 2006, income tax expense was $1.6 million as compared to $11,000 for the year ended December 31, 2005.
Income earned in the United States, where Sohu.com Inc. is incorporated, is subject to taxation at 34% or 35%. For the foreseeable future, we anticipate the major source of income earned in the United States and subject to United States taxation to be interest income. If dividends are paid by our China or other non-U.S. subsidiaries to Sohu.com Inc., the dividends would be taxed at Sohu.com Inc.’s rate of taxation, which is 34% or 35% (as reduced by any applicable “deemed-paid” foreign tax credits for foreign income taxes paid by such subsidiaries). For the foreseeable future, we do not intend for the China or other non-U.S. subsidiaries to pay dividends to Sohu.com Inc.
Minority Interests
On October 31, 2006, we completed the acquisition of a 70% interest in 21 East HK and 21 East Beijing (collectively “21 East”), an entertainment company. The acquisition had been accounted for as a purchase business combination and the results of operations from the acquisition date have been included in our consolidated financial statements, resulting in minority interests of $7,000.
Net Income from Continuing Operations
For the year ended December 31, 2006, income from continuing operations was $26.7 million, as compared to $31.1 million for the year ended December 31, 2005.
Loss from Discontinued E-commerce Operations
On June 20, 2006, we discontinued our e-commerce business. For the year ended December 31, 2006, loss from discontinued e-commerce operations was $841,000, as compared to $1.3 million for the year ended December 31, 2005. As of the date we discontinued our e-commerce operations, we had performed a specific review on all the assets related to the e-commerce segment. We provided an additional allowance for doubtful receivables amounting to $154,000 and allowance on all inventory balances amounting to $134,000 in June 2006 when we discontinued the e-commerce business. As the fixed assets previously used by the e-commerce operation could generally be used by other segments, we did not dispose of significant fixed assets nor provide any impairment charge.
Net Income
As a result of the foregoing, we had net income of $25.9 million for the year ended December 31, 2006, as compared to net income of $29.8 million for the year ended December 31, 2005. The net income for the year ended December 31, 2006 included $6.9 million of share-based compensation expense recorded under SFAS 123(R). The net income for the year ended December 31, 2005 included $2,000 of share-based compensation expense recorded under APB 25.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In September 2006, the Financial Accounting Standards Board issued FASB Statement No. 157, Fair Value Measurements (or SFAS 157), which defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies to other accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. However, on February 12, 2008, the FASB issued FSP FAS 157-2 which would delay the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This FSP partially defers the effective date of Statement 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. Effective for 2008, we will adopt SFAS 157 except as it applies to those nonfinancial assets and nonfinancial liabilities as noted in FSP FAS 157-2. We are currently evaluating the potential impact on our financial statements, if any, upon adoption of this standard.
In December 2007, the Financial Accounting Standards Board issued FASB Statement No. 141 (Revised 2007), Business Combinations (or SFAS 141R). SFAS 141R provides additional guidance on improving the relevance, representational faithfulness, and comparability of the financial information that a reporting entity provides in its financial reports about a business combination and its effects. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We believe there will be no material impact on our financial statements upon adoption of this standard.
In December 2007, the Financial Accounting Standards Board issued FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51 (“SFAS 160”). SFAS 160 amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This Statement is effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008. We believe there will be no material impact on our financial statements upon adoption of this standard.
In December 2007, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin 110 (“SAB 110”). SAB 110 states that the staff will continue to accept, under certain circumstances, the use of the simplified method for estimating the expected term of “plain vanilla” share options in accordance with SFAS 123(R) beyond December 31, 2007. We believe there will be no material impact on our financial statements upon adoption of this standard.
QUARTERLY RESULTS OF OPERATIONS
Demonstrating our full dedication to our core business of online advertising, on June 20, 2006, we discontinued our unprofitable e-commerce business. As a result of the discontinuation of this business, the e-commerce business is accounted for as discontinued operations. Accordingly, our statements of operations separate the discontinued operation for all periods presented.
In 2007, we adjusted our reportable segments and have reclassified results of our online game segment from our other operations and reported online game results as a separate segment. Accordingly, we reclassified the revenue and cost of revenue of the online game segment for the years prior to 2007 to conform with the current year classification.
Prior to 2007, most of the costs and expenses of the game department were related to product development and research. Accordingly, we recorded all such costs and expenses in product development expenses in the statements of operations. In 2007, in order to better present operating results and enhance comparability with industry peers, we reclassified expenses in relation to game operations, mainly salary and benefits of game masters, from product development expense to cost of online game revenues. To conform with current period presentations, the relevant amounts for prior periods have been reclassified.
The following table sets forth, for the periods presented, our unaudited quarterly results of operations for the eight quarters ended December 31, 2007. The data has been derived from our consolidated financial statements and, in our management’s opinion, they have been prepared on substantially the same basis as the audited consolidated financial statements and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the financial results for the periods presented. This information should be read in conjunction with the annual consolidated financial statements included elsewhere in this Form 10-K. The operating results in any quarter are not necessarily indicative of the results that may be expected for any future period.
LIQUIDITY AND CAPITAL RESOURCES
We have financed our operations and capital expenditures principally through sales of equity securities, public offering of common shares and convertible notes, and cash provided by operations. From inception through December 31, 2007, we have raised net proceeds of $39.2 million through the sale of preferred stock in private placements, $52.4 million from the sale of common stock in our initial public offering and $87.4 million through the sale of zero coupon convertible senior notes. As of December 31, 2007, we had cash and cash equivalents, and investments in marketable debt securities totaling approximately $122.7 million, compared to $129.7 million and $133.1 million as of December 31, 2006 and 2005, respectively.
We completed a private placement on July 14, 2003 of $90.0 million principal amount of zero coupon convertible senior notes due July 2023, which resulted in net proceeds to Sohu of approximately $87.4 million after deduction of the initial purchaser’s discount and our offering expenses. The notes do not pay any interest, have a zero yield to maturity, and are convertible into Sohu’s common stock at a conversion price of $44.76 per share, subject to adjustment for dividends, distributions, and upon the occurrence of certain other events. Each $1,000 principal of the notes is initially convertible into 22.3414 shares of Sohu’s common stock. Each holder of the notes will have the right, at the holder’s option, to require Sohu to repurchase all or any portion of the principal amount of the holder’s notes on July 14 in 2007, 2013 and 2018 at a price equal to 100% of the outstanding principal amount. Sohu may also redeem all or a portion of the notes for cash at any time on or after July 14, 2008 at 100% of the principal amount of the notes if the closing price of Sohu’s common stock for each of the 30 consecutive trading days prior to such time was at least 130% of the conversion price or at such time at least 90% of the initial aggregate principal amount of the notes have been converted, repurchased or redeemed. In addition, upon a change of control event, each holder of the notes may require Sohu to repurchase some or all of its notes at a repurchase price equal to 100% of the principal amount of the notes. During the year ended December 31, 2005, we early redeemed from the market a portion of our zero coupon convertible senior notes with face value of $15,220,000 at a discount. During the year ended December 31, 2006, we early redeemed from the market a portion of our zero coupon convertible senior notes at a discount for $15,000,000 in aggregate face value. As of the end of the notification period associated with the July 14, 2007 repurchase date, note holders had exercised their right to require us to repurchase such notes in an aggregate principal amount of $58.5 million. We repurchased such notes on July 16, 2007. In November 2007, the majority of remaining note holders with $1,250,000 in face amount of convertible notes exercised their right to convert their notes to our common stock at a conversion price of $44.76 per share. As of December 31, 2007, the outstanding balance of zero coupon convertible senior notes was $6,000.
Our principal commitments consist of obligations under various operating leases for office facilities in Beijing, Shanghai, Guangzhou and Hong Kong. Our commitments under these leases total approximately $1.1 million, $714,000 and $649,000 for the years ending December 31, 2008, 2009 and 2010, respectively. We expect that capital expenditures, totaling $20 million in 2008 will consist of $16.2 million for purchases of servers, network equipment and software and $3.8 million for miscellaneous purchases. In addition, Sohu was selected as the official sponsor of the ICS category for the Beijing 2008 Olympic Games, and entered into a sponsorship agreement with the BOCOG. Under the sponsorship agreement, Sohu is obliged to provide services regarding the construction, operation and maintenance of the Official Website for the Beijing 2008 Olympic Games throughout the sponsorship period ending December 31, 2008.
As described above, we have entered into arrangements with Dr. Zhang, our Chief Executive Officer, and certain of our employees to satisfy PRC regulations which prohibit or restrict foreign companies from owning or operating telecommunications, Internet content and certain other businesses in China. These arrangements have taken the form of loans to Dr. Zhang and the employees, who then invested the amounts loaned in what are currently our VIEs. While the arrangements have taken the form of loans to Dr. Zhang and the employees, they are, in substance, investments in the VIEs. Accordingly, we do not expect the loans to have any special effect upon our liquidity. The loan agreements do not contain any material financial covenants.
In summary, our cash flows were (in thousands):
For the year ended December 31, 2007, net cash provided by operating activities was $91.4 million. This was primarily attributable to our net income of $34.9 million, adjusted by non-cash items of depreciation and amortization of $12.9 million, share-based compensation expense of $8.8 million, provision for allowance for doubtful accounts of $1.7million, and a $33.4 million decrease in working capital. This increase was offset by excess tax benefits of $247,000 from share-based payment arrangements. For the year ended December 31, 2006, net cash provided by operating activities was $36.8 million. This was primarily attributable to our net income of $25.9 million, adjusted by non-cash items of depreciation and amortization of $10.0 million, share-based compensation expense of $6.9 million, provision for allowance for doubtful accounts of $1.1 million. This increase was offset by gains on early redemption of zero coupon convertible senior notes of $793,000, excess tax benefits of $431,000 from share-based payment arrangements and a $5.9 million increase in working capital. For the year ended December 31, 2005, net cash provided by operating activities was $35.9 million. This was primarily attributable to our net income of $29.8 million, adjusted by non-cash items of depreciation and amortization of $8.6 million, provision for allowance for doubtful accounts of $1.3 million. This increase was offset by gains on early redemption of zero coupon convertible senior notes of $1.3 million, and a $2.9 million increase in working capital.
For the year ended December 31, 2007, net cash used in investing activities was $49.7 million, and was primarily attributable to $55.8 million used in purchasing fixed assets and other assets, and $1.1 million for an earn-out payment for Go2Map. This amount was partially offset by $5.0 million received as a result of the maturities of marketable debt securities, $1.7 million in proceeds from disposal of interest in an associate, and a $450,000 decrease in restricted cash. For the year ended December 31, 2006, net cash used in investing activities was $10.2 million, and was primarily attributable to the purchase of fixed assets of $11.3 million, $3.8 million for acquisition of 21 East and earn-out payment for Focus.cn, an increase in restricted cash of $3.8 million, and the addition of intangible assets and other assets of $359,000. This amount was partially offset by $9.0 million received as a result of the maturities of marketable debt securities. For the year ended December 31, 2005, net cash used in investing activities was $17.1 million, and was primarily attributable to $10.3 million in cash used to acquire Go2Map and earn-out payment for Focus.cn, the purchase of fixed assets of $8.1 million largely due to the relocation of our offices in Beijing, and the addition of intangible assets and other assets of $2.4 million and the addition of restricted cash of $991,000. This amount was partially offset by $4.7 million received as a result of the maturities of marketable debt securities.
For the year ended December 30, 2007, net cash used in financing activities was $47.5 million, and was primarily attributable to $58.5 million used in redemption of zero coupon convertible senior notes. This amount was partially offset by $10.8 million cash collection from issuance of common stock upon the exercise of share-based awards granted under our stock incentive plan and $247,000 in excess tax benefits from share-based payment arrangements. For the year ended December 31, 2006, net cash used in financing activities was $23.8 million, and was primarily attributable to $15 million used for the repurchase of our common stock and $14.1 million used for early redemption of our zero coupon convertible senior notes. This amount was partially offset by $4.8 million received from the issuance of common stock upon the exercise of options granted under our stock incentive plan, and $431,000 in excess tax benefits from share-based payment arrangements. For the year ended December 31, 2005, net cash used in financing activities was $24.3 million, and was primarily attributable to $13.8 million used for the repurchase of our common stock and $13.8 million used for early redemption of our zero coupon convertible senior notes. This amount was partially offset by $3.3 million received from the issuance of common stock upon the exercise of options granted under our stock incentive plan.
We believe that current cash and cash equivalents will be sufficient to meet anticipated working capital (net cash used in operating activities), commitments and capital expenditures for at least the next twelve months. We may, however, require additional cash resources due to changed business conditions or other future developments, including any investments or acquisitions we may decide to pursue.
Tabular Disclosure of Contractual Obligations (in thousands)
The following table sets forth our contractual obligations as of December 31, 2007:
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
FOREIGN CURRENCY EXCHANGE RATE RISK
While our reporting currency is the US dollar, to date the majority of our revenues and costs are denominated in RMB and a significant portion of our assets and liabilities are denominated in RMB. As a result, we are exposed to foreign exchange risk as our revenues and results of operations may be affected by fluctuations in the exchange rate between US Dollar and RMB. If the RMB depreciates against the US Dollar, the value of our RMB revenues and assets as expressed in our US Dollar financial statements will decline. We do not hold any derivative or other financial instruments that expose us to substantial market risk. See “Risk Factors-We may suffer currency exchange losses if the RMB depreciates relative to the US Dollar.”
The RMB is currently freely convertible under the “current account”, which includes dividends, trade and service-related foreign exchange transactions, but not under the “capital account”, which includes foreign direct investment. In addition, commencing on July 21, 2005, China reformed its exchange rate regime by changing to a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. Under the managed floating exchange rate regime, the RMB is no longer pegged to the US Dollar. The exchange rate of the RMB against the US Dollar was adjusted to RMB 8.11 per US Dollar as of July 21, 2005, representing an appreciation of about 2%. The People’s Bank of China will announce the closing prices of foreign currencies such as the US Dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market on each business day, and will make such prices the central parity for trading against the RMB on the following business day. On May 19, 2007, the People’s Bank of China announced a policy to expand the maximum daily floating range of RMB trading prices against the U.S. dollar in the inter-bank spot foreign exchange market from 0.3% to 0.5%. While the international reactions to the RMB revaluation and widening of the RMB’s daily trading band have generally been positive, with the increased floating range of the RMB’s value against foreign currencies, the RMB may appreciate or depreciate significantly in value against the U.S. dollar or other foreign currencies in the long term, depending on the fluctuation of the basket of currencies against which it is currently valued. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the effectiveness of these hedges may be limited and we may not be able to successfully hedge our exposure. Accordingly, we may incur economic losses in the future due to foreign exchange rate fluctuations, which could have a negative impact on our financial condition and results of operations.
The following table provides information, by maturity date, regarding our foreign currency sensitive financial instruments, which consist of cash and cash equivalents, restricted cash, receivables, payables and zero coupon convertible senior notes as of December 31, 2007:
INVESTMENT RISK
(a) Investments in High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age
As of December 31, 2007, Sohu had outstanding long-term loans of $11.4 million to Dr. Zhang, Sohu’s Chief Executive Officer and a major Sohu shareholder, and certain of our employees. The long-term loans are used to finance investments in High Century, which is owned 80% by Dr. Zhang and 20% by an employee; Sohu Entertainment, which is owned by two of our employees; Goodfeel, which is owned by two of our employees; Huohu, which is owned 75% by Sohu Era and 25% by an employee; Sogou Information, which is owned by two of our employees; and Gamease Age, which is owned by two of our employees. High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age are used to facilitate our participation in telecommunications, Internet content and certain other businesses in China where foreign ownership is either prohibited or restricted.
The agreements contain provisions that, subject to PRC law, (i) the loans can only be repaid to us by transferring the shares of High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information or Gamease Age to us; (ii) the shares of High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information or Gamease Age cannot be transferred without our approval; and (iii) we have the right to appoint all directors and senior management personnel of High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age. Dr. Zhang and the other employee borrowers have pledged all of their shares in High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age as collateral for the loans and the loans bear no interest and are due on demand after November 2003 in the case of High Century; after November 2005 in the case of Huohu; after August 12, 2006 in the case of Sogou Information; after October 2006 in the case of Goodfeel; after November 3, 2006 in the case of Sohu Entertainment; after September 2008 in the case of Gamease Age, or, in any case, at such time as Dr. Zhang or the other employee borrowers, as the case may be, is not an employee of Sohu. Sohu does not intend to request repayment of the loans as long as PRC regulations prohibit it from directly investing in businesses being undertaken by the VIEs.
Because these loans can only be repaid by the borrowers’ transferring the shares of the various entities, our ability to ultimately realize the effective return of the amounts advanced under these loans will depend on the profitability of High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age which is uncertain.
Furthermore, because of uncertainties associated with the PRC law, ultimate enforcement of the loan agreements is uncertain. Accordingly, we may never be able to collect these loans or exercise influence over High Century, Sohu Entertainment, Goodfeel, Huohu, Sogou Information and Gamease Age.
In addition, under Section 402 of the Sarbanes-Oxley Act of 2002, issuers subject to the act are prohibited from making personal loans to their directors and executive officers. Under Section 402, issuers are permitted to maintain the loans they made to directors and executive officers prior to the effective date of the Sarbanes-Oxley Act. They are not permitted, however, to renew or materially modify such loans. We believe that there is a strong argument that the loans to Dr. Zhang described above are not “personal loans,” in view of our underlying business purpose for making the loans and the lack of a personal benefit to Dr. Zhang from the loans. In the absence of judicial interpretation, an SEC rule, or an SEC staff interpretation confirming our conclusion, however, we intend to treat these loans as if they were “personal loans” under Section 402 of the Sarbanes-Oxley Act. Accordingly, we expect that if we enter into arrangements similar to those described above in the future, any loans made under such arrangements will be made to individuals who are not our directors or executive officers. In addition, should the existing loans to Dr. Zhang, or to the entities in which he is the primary shareholder, need to be renewed or materially modified, such as if we need to advance additional funds to any of these entities, we expect that the entities, the ownership of the entities and/or the loans to the entities will be restructured so that we could not be deemed to be making a loan to Dr. Zhang. The prohibitions set forth in Section 402 have not had any adverse effect on our operations to date, and we do not expect them to have any adverse effect in the future.
INTEREST RATE RISK
Our investment policy limits our investments of excess cash in high-quality corporate securities and limits the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market and reinvestment risk.
The following table provides information, by maturity date, regarding our interest rate sensitive financial instruments, which mainly were zero coupon convertible senior notes as of December 31, 2007.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the Index to Consolidated Financial Statements which appear on page of this report. The Management’s Report on Internal Control over Financial Reporting, Report of Independent Registered Public Accounting Firm, Consolidated Financial Statements, Notes to Consolidated Financial Statements and Financial Statements Schedules which are listed in the Index to Consolidated Financial Statements and which appear beginning on page of this report are incorporated into this Item 8. Quarterly Results of Operations information is included on page 56 of this report and is incorporated into this Item 8.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report (the “Evaluation Date”), have concluded that as of the Evaluation Date our disclosure controls and procedures were effective and designed to ensure that all material information relating to Sohu required to be included in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and to ensure that information required to be disclosed is accumulated and communicated to our management, including our principal executive and financial officers, as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control over Financial Reporting
Our management’s annual report on internal control over financial reporting and the related report of our independent registered public accounting firm are included in this Report on pages and, respectively.
Changes in Internal Control Over Financial Reporting
There have not been any changes in the Company’s internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act during the Company’s fiscal quarter ended December 31, 2007 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this item will be included in the Proxy Statement for Sohu’s 2007 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission on or about April 30, 2008 and is incorporated herein by reference.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item will be included in the Proxy Statement for Sohu’s 2007 Annual Meeting of Stockholders under the heading “Executive Compensation” and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item, other than the table included below, will be included in the Proxy Statement for Sohu’s 2007 Annual Meeting of Stockholders under the heading “Beneficial Ownership of Common Stock” and is incorporated herein by reference.
Equity Compensation Plan Information
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this item will be included in the Proxy Statement for Sohu’s 2007 Annual Meeting of Stockholders under the heading “Certain Relationships and Related Transactions” and is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item will be included in the Proxy Statement for Sohu’s 2007 Annual Meeting of Stockholders under the heading “Principal Accountant Fees and Services” and is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)(1) Index to Consolidated Financial Statements
Please see the accompanying Index to Consolidated Financial Statements which appears on page of this report. The Management’s Report on Internal Control over Financial Reporting, Report of Independent Registered Public Accounting Firm, Consolidated Financial Statements and Notes to Consolidated Financial Statements which are listed in the Index to Consolidated Financial Statements and which appear beginning on page of this report are included in Item 8 above.
(a)(2) Financial Statements Schedule
Schedule I, Condensed Financial Information of Registrant, is included on page of this report and is incorporated into this Item 15(a)(2) by reference.
All other financial statements schedules have been omitted because the information required to be set forth therein is not applicable or is included in the Consolidated Financial Statements or notes thereto.
(b) Exhibits
See the Exhibit Index following the signature pages of this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized.
Date: February 28, 2008
Sohu.com Inc.
By:
/s/ CAROL YU
Carol Yu
Co-President and Chief Financial Officer
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Charles Zhang and Carol Yu, and each of them, his true and lawful proxies, attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to (i) act on, sign and title with the SEC any and all amendments to this Annual Report on Form 10-K, together with all exhibits thereto, (ii) act, sign and file such certificates, instruments, agreements and other documents as may be necessary or appropriate in connection therewith, and (iii) take any and all actions which may be necessary or appropriate in connection therewith, granting unto such agents, proxies and attorneys-in-fact, and each of them and his and their substitute or substitutes, full power and authority to do and perform each and every act and thing necessary or appropriate to be done in connection therewith, as fully for all intents and purposes as he might or could do in person, hereby approving, ratifying and confirming all that such agents, proxies and attorneys-in-fact, any of them or any of his or their substitute or substitutes may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SOHU.COM INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
All other schedules have been omitted because the information required to be set forth therein is not applicable or is shown in the Consolidated Financial Statements or Notes.
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of its internal control over financial reporting based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, the Company’s management concluded that its internal control over financial reporting was effective as of December 31, 2007.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. The effectiveness of our internal control over financial reporting as of December 31, 2007 has been audited by PricewaterhouseCoopers Zhong Tian CPAs Limited Company, an independent registered public accounting firm, as stated in their report which is included herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To Board of Directors and Shareholders of Sohu.com Inc.:
We have completed integrated audits of Sohu.com Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2007, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Sohu.com Inc. and its subsidiaries at December 31, 2007 and December 31, 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in management’s report on internal control over financial reporting appearing on Page of Form 10-K. Our responsibility is to express opinions on these financial statements, on the financial statement schedule, and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 2(r) to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation since January 1, 2006.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
PricewaterhouseCoopers Zhong Tian CPAs Limited Company
Beijing, the People’s Republic of China
February 28, 2008
SOHU.COM INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
SOHU.COM INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
Effective from January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (“SFAS 123(R)”), which requires all share-based awards to employees and directors to be recognized in the financial statements based on their grant date fair values. Net income for the year ended December 31, 2007 included share-based compensation expense under SFAS 123(R), including $1.7 million in cost of revenues, $2.8 million in product development expenses, $1.5 million in sales and marketing expenses, and $2.8 million in general and administrative expenses. Net income for the year ended December 31, 2006 included share-based compensation expense under SFAS 123(R), including $1.5 million in cost of revenues, $1.9 million in product development expenses, $1.6 million in sales and marketing expenses, and $1.9 million in general and administrative expenses. Please refer to Note 18 to the Consolidated Financial Statements for additional information.
The accompanying notes are an integral part of these consolidated financial statements.
SOHU.COM INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
SOHU.COM INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
SOHU.COM INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Nature of Operations
Sohu.com Inc. (the “Company” or “Sohu”) is a leading online media, search, online game and mobile value-added services company providing comprehensive online products and services to consumers and businesses in the People’s Republic of China (the “PRC” or “China”). The Company, a Delaware corporation, commenced operations in 1996.
The Company, its subsidiaries and variable interest entities (“VIEs”), primarily offer content, brand advertising, sponsored search, online game and wireless services through the Company’s Internet sites, www.sohu.com, www.sogou.com, www.17173.com, www.focus.cn, www.chinaren.com, www.go2map.com and www.goodfeel.com.cn. The Company markets its products and services to customers primarily in the PRC.
2. Summary of Significant Accounting Policies
(a) Accounting Standards
The consolidated financial statements have been prepared on a historical cost basis to reflect the financial position and results of operations of the Company in accordance with accounting principles generally accepted in the United States of America.
(b) Consolidation
The consolidated financial statements include the accounts of the Company, its subsidiaries and its VIEs from the respective dates of their acquisition or formation. All intercompany balances and transactions have been eliminated.
The Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 46R, “Consolidation of Variable Interest Entities” (“FIN 46R”). Pursuant to FIN 46R, Beijing Century High Tech Investment Co., Ltd. (“High Century”), Beijing Sohu Entertainment Culture Media Co., Ltd. (“Sohu Entertainment”), formally known as Beijing Hengda Yitong Internet Technology Development Co., Ltd. (“Hengda”), Beijing Sohu Internet Information Service Co., Ltd. (“Sohu Internet”), Beijing Goodfeel Information Technology Co., Ltd. (“Goodfeel”), Beijing Huohu Digital Technology Co., Ltd. (“Huohu”), Beijing Tu Xing Tian Xia Information Consultancy Co., Ltd. (“Tu Xing Tian Xia”), Beijing Feng Yang Tian Lang Advertising Co., Ltd. (“Feng Yang Tian Lang”), Beijing Sogou Information Service Co., Ltd. (“Sogou Information”), Guangzhou Sohu Interactive Network Technology Co., Ltd. (“Guangzhou Interactive”) and Beijing Gamease Age Digital Technology Co., Ltd. (“Gamease Age”) are VIEs of the Company and the Company is the primary beneficiary of the VIEs. Accordingly, the VIEs have been consolidated in the Company’s financial statements.
(c) Use of estimates
The Company’s discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company 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 on-going basis, the Company evaluates its 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. The Company believes accounting for brand advertising and sponsored search revenues, accounting for online game revenues, accounting for wireless revenues and cost of revenues, gross versus net basis of revenue recognition, determination of functional currencies, allowance for doubtful accounts, assessment of impairment for goodwill, intangible assets, fixed assets and other assets, determination of share-based compensation expense and assessment of valuation allowance against deferred tax assets, represent critical accounting policies that reflect the more significant judgments and estimates used in the preparation of its consolidated financial statements.
(d) Revenue recognition
The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. The Company derives revenue from both advertising and non-advertising sources.
i) Advertising revenues
Advertising revenues include revenue from brand advertising and sponsored search services, after deducting agent rebates and applicable business tax. No revenues from advertising-for-advertising barter transactions were recognized.
Brand advertising contracts establish the fixed price and advertising services to be provided. Pursuant to brand advertising contracts, the Company provides advertisement placements on various Website channels and in different formats, including but not limited to banners, links, logos, buttons, rich media and content integration. Revenue is recognized ratably over the period the advertising is provided and, as such, the Company considers the services to have been delivered. The Company treats all elements of advertising contracts as a single unit of accounting for revenue recognition purposes. Based upon the Company’s credit assessments of its customers prior to entering into contracts, the Company determines if collectibility is reasonably assured. In situations where collectibility is not deemed to be reasonably assured, the Company recognizes revenue upon receipt of cash from customers.
Sponsorship contracts may include services similar to those in the brand advertising contracts, are generally for larger dollar amounts and for a longer period of time, may allow advertisers to sponsor a particular area on the Websites of the Company, may include brand affiliation services and/or a larger volume of services, and may require some exclusivity or premier placements. Sponsorship advertisement revenues are normally recognized on a straight-line basis over the contract period, provided the Company is meeting its obligations under the contract.
Pursuant to sponsored search contracts, which are normally for relatively small dollar amounts and are with small and medium size enterprises, sponsored search services mainly include priority placements in the Company’s search directory and pay-for-click services consisting of displaying the text-based links to the Websites of the Company’s advertisers and the Company’s Website Alliance network. The Company normally provides the priority placements services for a fixed fee over the service period of the contracts. Revenues of these services are normally recognized on a straight-line basis over the service period of the contracts. Pay-for-click services of displaying the text-based links to the Company’s advertisers’ Websites is charged on a cost per click basis, so that an advertiser pays the Company only when a user clicks on the displayed link. The priority of the display of text-based links is based on the bidding price of different advertisers. Revenues from the pay-for-click services are recognized as the users click on the links.
ii) Non-advertising revenues
Non-advertising revenues include revenue principally from online game and wireless services.
Online game revenues are collected through sale of the Company’s prepaid cards, which it sells in both virtual and physical form, to third party distributors and retailers. Prior to December 2006, the Company operated its massively multi-player online role-playing games (“MMORPG game”) under a time-based model. Under this model, the proceeds from sale of prepaid cards from distributors or retailers are deferred when received and revenue is recognized based upon the actual usage of time units by the end users. In December 2006, the Company changed the revenue model from time-based to item-based. Under the new item-based model, players play a game on a free of charge basis and with the ability to purchase in-game premium features. Proceeds from sale of prepaid cards are deferred when received and revenue is recognized over the estimated lives of the premium features purchased or as the premium features are consumed. However, if different assumptions were used and resulted in a different estimate of the average period, it may impact the timing that the Company records its revenues.
Wireless revenues are derived from providing short messaging services or SMS, Ring Back Tone or RBT, Wireless Application Protocol or WAP, multi-media messaging services or MMS and interactive voice response or IVR, mainly consisting of news, weather forecast, chatting, entertainments information, ring tones, and logo downloads and various other mobile related products provided to mobile phone users. The Company contracts with third party mobile network operators for wireless services provided to its users and records the fee charged by third party mobile network operators as cost of revenues. Wireless revenues are recognized in the month in which the service is performed, provided that no significant company obligations remain.
Wireless revenues are recorded on a gross basis as the Company is the primary obligor in the arrangement, which is evidenced by a number of factors including that the content and the nature of the wireless services are designed and developed by the Company (either independently or with third parties) and originates from the Company’s Websites, the links located on third parties’ Websites, or one of the dedicated phone numbers of the Company. Also, the mobile network operators that the Company contracts with to deliver these services to the end customers are not involved in the design or development of the services that are provided by the Company. The end customer purchases the wireless content, community access or value-added services that the Company provides. The end customer receives identical services from the Company regardless of which third party mobile network operator is used to deliver the message. In addition, the Company provides customer services to the end customers directly and it could be requested by the mobile network operators to assume the credit risk if the operators are not able to collect fees from the end customers. The Company is primarily responsible for fulfillment, adds value to the products, has inventory risk related to the content and products, and has reasonable pricing latitude.
(e) Cash and cash equivalents
The Company considers all highly liquid investments with an original maturity of three months or less when purchased to be cash equivalents. Cash equivalents are composed primarily of investments in money market accounts stated at cost, which approximates fair value.
(f) Accounts receivable, net
The carrying amount of accounts receivable is reduced by a valuation allowance that reflects the Company’s best estimate of the amounts that will not be collected. In addition to reviewing delinquent accounts receivable, the Company considers many factors in estimating its general allowance, including aging analysis, historical bad debt records, customer credit analysis and any specific known troubled accounts.
(g) Investments in marketable debt securities
The Company invests its excess cash in certain marketable debt securities of high-quality corporate issuers. The Company’s marketable debt securities are classified as available-for-sale and are reported at fair market values with the unrealized gains or losses recorded as accumulated other comprehensive income in shareholders’ equity. Additionally, the Company assesses whether an other-than-temporary impairment loss on investments in marketable debt securities has occurred due to declines in fair value or other market conditions. Declines in fair value that are considered other than temporary are recorded as an impairment of certain equity investments in the consolidated statement of income.
Investments in marketable debt securities with original maturities greater than twelve months when purchased are considered long-term investments. Long-term investments in marketable securities with maturities less than twelve months from the balance sheet date are recorded as current portion of long-term investments in marketable debt securities.
(h) Associates
Associates are entities over which the Company has significant influence, but which it does not control. Investments in associates are accounted for by the equity method of accounting. Under this method, the Company’s share of the post-acquisition profits or losses of associates is recognized in the income statement and its share of post-acquisition movements in reserves is recognized in reserves. Unrealized gains on transactions between the Company and its associates are eliminated to the extent of the Company’s interest in the associates; unrealized losses are also eliminated unless the transaction provides evidence of an impairment of the asset transferred. When the Company’s share of losses in an associate equals or exceeds its interest in the associates, the Company does not recognize further losses, unless the Company has incurred obligations or made payments on behalf of the associates.
(i) Fixed assets and depreciation
Fixed assets, comprising office buildings, investment properties, computer equipment and hardware, office furniture, vehicles and leasehold improvements, are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally two to five years, with no residual value for assets acquired after January 1, 2003. For computer equipment, office furniture and equipment acquired prior to this date, a residual value of five percent was used.
(j) Goodwill
Goodwill represents the excess of the purchase price over the fair value of the identifiable assets and liabilities acquired as a result of the Company’s acquisitions of interests in its subsidiaries and VIEs.
The Company tests goodwill for impairment at the reporting unit level (operating segment) on an annual basis as of October 1 or more frequently if an event occurs or circumstances change that could more likely than not reduce the fair value of the goodwill below its carrying amount. The impairment of goodwill is determined by the Company estimating the fair value based upon the present value of future cash flows. In estimating the future cash flows, the Company has taken into consideration the overall and industry economic conditions and trends, market risk of the Company and historical information.
(k) Intangible assets
Intangible assets, comprising domain names, trademarks, customer relationship, computer software purchased from unrelated third parties and others, are stated at cost less accumulated amortization. Amortization is computed using the straight-line method over the estimated useful lives of the assets, generally three years for customer lists and computer software and fifteen years for domain names and trademarks, with no residual value. The weighted average amortization period for intangible assets is five years.
(l) Other assets
Other assets mainly include the prepaid content fees and rental deposits. The Company amortizes content fees over the term of the contracts. During the three month period ended December 31, 2007, the estimated remaining economic lives for certain other assets were shortened as a result of latest events and circumstances. Accordingly, net income and earnings per share were reduced by $1.3 million and $0.04, respectively.
(m) Impairment for long-lived assets
The carrying amounts of long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is evaluated by a comparison of the carrying amount of assets to future undiscounted net cash flows expected to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amounts of the assets exceed the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.
(n) Foreign currency translation
Foreign currency transactions are translated at the applicable rates of exchange in effect at the transaction dates. Monetary assets and liabilities denominated in foreign currencies at the balance sheet date are translated at the applicable rates of exchange in effect at that date.
The Company’s functional and reporting currency is the US Dollar. The functional currency of the Company’s subsidiaries in China is the Renminbi (“RMB”). Sales and purchases and other expense transactions are generally denominated in RMB. Accordingly, assets and liabilities of the China subsidiaries are translated at the current exchange rate in effect at the balance sheet date, and revenues and expenses are translated at the average exchange rates in effect during the reporting period. Gains and losses resulting from foreign currency translation are recorded in a separate component of shareholders’ equity. Foreign currency translation adjustments are included in accumulated other comprehensive income in the consolidated statements of shareholders’ equity for the years presented.
(o) Cost of revenues
i) Advertising
Cost of advertising revenues consists of compensation and related overhead costs for employees, depreciation expenses, fees for bandwidth leasing charges, content and services. Royalties paid to content providers are expensed as incurred and included as cost of revenues. Contracts with content providers generally range from one to three years in duration and may be terminated by either party upon notice.
ii) Non-advertising
Cost of online game revenues consists of salary and benefits of game masters, bandwidth leasing charges and revenue sharing with the game developers.
Cost of wireless revenues consists of collection charges and transmission fees paid to third party network operators, payments to third party content suppliers, penalties, depreciation expenses, and fees for bandwidth leasing charges.
(p) Product development
Operating, classification and organization of listings, and enhancement costs of the Website are expensed as incurred. Significant direct costs of materials, labor and services incurred during the application development stage of a project are capitalized.
(q) Advertising expenses
Advertising expenses, which generally represent the cost of promotions to create or stimulate a positive image of the Company or a desire to buy the Company’s products and services, are expensed as incurred. Advertising expenses are charged to the statements of operations when incurred. Included in sales and marketing expenses are advertising costs of $22.5 million, $10.6 million and $7.6 million, for the years ended December 31, 2007, 2006 and 2005, respectively.
(r) Share-based compensation
Effective from January 1, 2006, the Company adopted SFAS 123(R), which requires all share-based payments to employees and directors, including grants of employee stock options and restricted stock units, to be recognized in the financial statements based on their grant date fair values. The valuation provisions of SFAS 123(R) apply to new awards, to awards granted to employees and directors before the adoption of SFAS 123(R) whose related requisite services had not been provided, and to awards which were subsequently modified or cancelled. In March 2005, the SEC issued SAB 107 regarding the SEC’s interpretation of SFAS 123(R) and the valuation of share-based payments for public companies. The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R). Prior to SFAS 123(R), the Company accounted for share-based payments in accordance with APB 25, and complied with the disclosure provisions of SFAS 123. In general, compensation cost under APB 25 was recognized based on the difference, if any, between the estimated fair value of our common stock and the amount an employee must pay to acquire the stock, as determined on the date the option is granted. Pro forma information was disclosed to illustrate the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation for the reporting periods.
Under SFAS 123(R), the Company applied the Black-Scholes valuation model in determining the fair value of options granted to employees and directors. Under the transition provisions of SFAS 123(R), the Company recognizes compensation expense on options granted prior to the adoption of SFAS 123(R) on an accelerated basis over the requisite service period, which is consistent with the methods the Company adopted when preparing pro forma information under SFAS 123. For the year ended December 31, 2007, the Company granted 250,529 restricted stock units to its employees and directors. Restricted stock units are measured based on the fair market value of the underlying stock on the dates of grant. The Company recognizes the relevant share-based compensation expenses on an accelerated basis over the requisite service period.
Under SFAS 123(R), the number of share-based awards for which the service is not expected to be rendered for the requisite period should be estimated, and the related compensation cost not recorded for that number of awards. For pro forma disclosure under SFAS 123, the effect of forfeitures was accounted for only as the forfeitures occurred. The Company applied the modified prospective transition method, and therefore has not restated prior years’ results.
(s) Income taxes
Income taxes are accounted for using an asset and liability approach which requires the recognition of income taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Deferred income taxes are determined based on the differences between the financial reporting and tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws. The measurement of deferred tax assets is reduced, if necessary, by the amount of any tax benefits that, based on available evidence, are not more likely than not be realized.
(t) Uncertain Tax Positions
The Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), on January 1, 2007. FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods, and income tax disclosures. The Company did not have any adjustment to the opening balance of retained earnings as of January 1, 2007 as a result of the implementation of FIN 48. For the year ended December 31, 2007, the Company did not have any interest and penalties associated with tax positions. As of December 31, 2007, the Company did not have any significant unrecognized uncertain tax positions.
(u) Net income per share
Basic net income per share is computed using the weighted average number of common shares outstanding during the year. Diluted net income per share is computed using the weighted average number of common and, if dilutive, potential common shares outstanding during the year. Potential common shares consist of shares issuable upon the exercise of stock options and restricted stock units (using the treasury stock method) and the conversion of zero coupon convertible senior notes.
(v) Comprehensive income
Comprehensive income is defined as the change in equity of a company during a period from transactions and other events and circumstances excluding transactions resulting from investments from owners and distributions to owners. Accumulated other comprehensive income, as presented on the accompanying consolidated balance sheets, consists of the unrealized gains on investments in marketable debt securities and the cumulative foreign currency translation adjustment.
(w) Segment reporting
In accordance with its internal financial reporting structure, the Company has determined that its business segments constitute its primary reporting segments. In previous years, the Company mainly had four reportable segments: brand advertising, sponsored search, wireless and others. In 2007, the Company adjusted its reportable segments and has reclassified results of its online game segment from its other operations and reported online game results as a separate segment. Accordingly, the Company reclassified the related revenue and cost of revenue for previous years presented to conform with the revised classification.
The Company does not allocate any operating expenses or assets to its brand advertising, sponsored search, online game, wireless and other segments as management does not use this information to measure the performance of the operating segments.
(x) Recent accounting pronouncements
In September 2006, the Financial Accounting Standards Board issued FASB Statement No. 157, Fair Value Measurements (or SFAS 157), which defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies to other accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. However, on February 12, 2008, the FASB issued FSP FAS 157-2 which would delay the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This FSP partially defers the effective date of Statement 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. Effective for 2008, we will adopt SFAS 157 except as it applies to those nonfinancial assets and nonfinancial liabilities as noted in FSP FAS 157-2. The Company is currently evaluating the potential impact on its financial statements, if any, upon adoption of this standard.
In December 2007, the Financial Accounting Standards Board issued FASB Statement No. 141 (Revised 2007), Business Combinations (“SFAS 141R”). SFAS 141R provides additional guidance on improving the relevance, representational faithfulness, and comparability of the financial information that a reporting entity provides in its financial reports about a business combination and its effects. This Statement applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The Company believes there will be no material impact on its financial statements upon adoption of this standard.
In December 2007, the Financial Accounting Standards Board issued FASB Statement No. 160, Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51 (“SFAS 160”). SFAS 160 amends ARB No. 51 to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This Statement is effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company believes there will be no material impact on its financial statements upon adoption of this standard.
In December 2007, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin 110 (“SAB 110”). SAB 110 states that the staff will continue to accept, under certain circumstances, the use of the simplified method for estimating the expected term of “plain vanilla” share options in accordance with SFAS 123(R) beyond December 31, 2007. The Company believes there will be no material impact on its financial statements upon adoption of this standard.
(y) Reclassification
Prior to 2007, most of the costs and expenses of the game department were related to product development and research. Accordingly, the Company recorded all such costs and expenses in product development expenses in the statements of operations. In 2007, in order to better present operating results and enhance comparability with industry peers, the Company reclassified expenses in relation to game operations, mainly salary and benefits of game masters, from product development expense to cost of online game revenues. To conform with current period presentations, the relevant amounts for prior periods have been reclassified accordingly. Such reclassification amounted to $1.3 million and $0.9 million for the year ended December 31, 2006 and 2005, respectively.
3. Discontinuance of E-commerce Operation
The Company discontinued its e-commerce platform of physical consumer goods on June 20, 2006, in order to focus on profitable segments. As a result of the disposal, the e-commerce business is accounted for as a discontinued operation. Accordingly, the Company’s consolidated statements of operations separate the discontinued operation for all years presented. For the years ended December 31, 2007, 2006 and 2005, revenues from the e-commerce operation amounted to $92,000, $1.2 million and $3.8 million, respectively. For the years ended December 31, 2007, 2006 and 2005, net loss from the e-commerce operation amounted to $20,000, $0.8 million and $1.3 million, respectively.
At the discontinuance of the e-commerce operation, the Company performed a specific review on all the assets related to the e-commerce segment, and provided full provisions for doubtful receivables and the entire inventory balances. As the fixed assets previously used by the e-commerce operation could generally be used by other segments, the Company did not dispose of significant fixed assets nor provide impairment on the fixed assets.
4. Segment Information
Based on the criteria established by SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”, the Company mainly operated in four principal segments: brand advertising, sponsored search, online game and wireless. In June 2006, the Company terminated its e-commerce business. Accordingly, the results of operations for e-commerce have been reclassified as loss from discontinued operation for all periods presented. In 2007, the Company adjusted its reported segments and reclassified the results of its online game segment from its other operations and now reported online game results as a separate segment. Such reclassification amounted to approximately $8.5 million and $5.8 million in revenues, $3.9 million and $2.7 million in cost of revenues for the years ended December 31, 2006 and 2005, respectively.
The Company does not allocate any operating expenses or assets to its brand advertising, sponsored search, online game, wireless and other segments as management does not use this information to measure the performance of the operating segments. Management does not consider share-based compensation for their segment reporting as shown in the tables, as such information does not impact the decisions on resource allocation and segment performance evaluation.
The following tables present summarized information by segment (in thousands):
5. Other Income
The following table summarizes the Company’s other income (in thousands):
6. Balance Sheet Components (in thousands)
7. Investment in an Associate
In August 2004, the Company made an investment of $997,000 in Beijing Pixel Software Technology Co. Ltd. (“Pixel”) to acquire 15% of its equity interest (the “Acquisition”). The Company has the right to appoint one of four members of the Board of Directors, who has the right to veto any cooperation between Pixel and competitors of the Company. The Company believes that it can exercise a significant influence on Pixel’s operations; accordingly, the investment was accounted for under the equity method. During the years ended December 31, 2007, 2006 and 2005, the Company recorded a share of profits of $9,000, $151,000 and $102,000 in the consolidated statements of operations, respectively. In August 2007, the Company disposed of its 15% equity interests in Pixel to the controlling shareholders of Pixel. Accordingly, starting from September 1, 2007, Pixel ceased to be an associate of the Company.
8. Goodwill
The changes in the carrying amount of goodwill by segment are as follows (in thousands):
As of December 31, 2007, the Company performed a goodwill impairment test by comparing the book value to the fair value of each reporting unit. Based on assessment, the fair value of each reporting unit is greater than the book value thus no impairment charge was recorded. In estimating the fair value of a reporting unit, the Company has taken into consideration the overall and industry economic conditions and trends, market risk of the Company and historical information. Going forward, the Company will continue to test goodwill for impairment on an annual basis or more frequently if an event occurs or circumstances change that could more likely than not reduce the fair value of the goodwill below its carrying amount.
9. Intangible Assets, Net
The following table summarizes the Company’s intangible assets, net (in thousands):
Amortization expense for the years ending December 31, 2008, 2009, 2010, 2011 and 2012 is estimated to be $2,239,000, $1,056,000, $782,000, $601,000 and $530,000, respectively.
10. Restricted cash
As of December 31, 2007 and 2006, the Company had made deposits of $4.3 million and $4.8 million, respectively, into restricted bank accounts as guarantees to meet the requirements under certain content purchase and marketing rights contracts.
11. Acquisitions
(a) 21 East
On October 31, 2006, the Company completed the acquisition of a 70% interest in 21 East Entertainment Limited (“21 East Hong Kong”) and Beijing 21 East Culture Development Co., Ltd. (“21 East Beijing”) (collectively “21 East”) for consideration of $3.5 million in cash and an additional amount, not to exceed $1.4 million, which will be paid over three years after the date of the closing of the acquisition, subject to the satisfaction and attainment of certain post closing operating and financial milestones of 21 East. Other estimated direct acquisition costs were $219,000. The main purpose of the acquisition of the 70% interest in 21 East is to enable the Company to secure and develop attractive, high-quality music and content. The Company considers the acquisition of 21 East to have been made in the ordinary course of its business. The purchase price was determined based on arms’ length negotiations between Sohu and 21 East.
The acquisition had been accounted for as a purchase business combination and the results of operations from the acquisition date have been included in the Company’s consolidated financial statements in accordance with SFAS 94. The allocation of the purchase price is as follows (in thousands):
The excess of purchase price over tangible assets and identifiable intangible assets (mainly copyrights of song lyrics) acquired and liabilities assumed were recorded as goodwill relating to the wireless segment. The purchase price used in the calculation of goodwill excludes contingent consideration of $1.4 million and contingent taxes obligations relating to the pre-acquisition period, which may result in recognition of an additional element of cost of the acquisition entity when the outcome of the contingencies, if any, become estimable. The identifiable intangible assets were amortized over a weighted average period of three years.
Prior to the acquisition, 21 East did not prepare its financial statements under accounting principles generally accepted in the United States of America. The Company determined that the cost of reconstructing the financial statements of 21 East for the periods prior to the acquisition outweighed its benefits. Accordingly, unaudited pro forma consolidated financial information reflecting the results of operations of 21 East has not been presented.
(b) Go2Map
On May 31, 2005, the Company completed the acquisition of all of the outstanding capital stock of Go2Map Inc., a company incorporated in Cayman Islands, and all of the registered share capital of Tu Xing Tian Xia, a company incorporated in the PRC which was an affiliate of Go2Map Inc. (collectively “Go2Map”) for $9.3 million in cash, and an additional amount, not to exceed $2.5 million, which will be paid over two years after the date of the closing of the acquisition, subject to the satisfaction and attainment of certain post closing operating and financial milestones of Go2Map. In 2007 and 2006, $545,000 and $520,000 was payable based upon the achievement of certain operating and financial milestones of Go2Map, respectively. The other direct acquisition costs amounting to $454,000 were paid during the year ended December 31, 2005. Go2Map is one of the leading online mapping service providers in China. The Company considers the acquisition of Go2Map to have been made in the ordinary course of its business. The purchase price was determined in arms’ length negotiations between Sohu and Go2Map.
The acquisition had been accounted for as a purchase business combination and the results of operations from the acquisition date have been included in the Company’s consolidated financial statements. The allocation of the purchase price is as follows (in thousands):
The excess of purchase price over tangible and identifiable intangible assets (mainly trade name, non-compete agreements and customer relationship) acquired and liabilities assumed were recorded as goodwill relating to the sponsored search segment. Purchase price used in the calculation of goodwill excludes the remaining contingent consideration not exceeding $2.5 million, which may result in recognition of an additional element of cost of the acquired entity when the outcome of the contingency is materialized. During 2007 and 2006, the Company recorded the effects of materialization of the contingent consideration of $545,000 and $520,000 for the acquisition, respectively. The acquired identifiable intangible assets were valued by various approaches, including income approach, market approach and replacement cost approach, as appropriate. Identifiable intangible assets were amortized over a weighted average period of six years.
Prior to the acquisition, Go2Map did not prepare its financial statements under accounting principles generally accepted in the United States of America. The Company determined that the cost of reconstructing the financial statements of Go2Map for the periods prior to the acquisition outweighed its benefits. Accordingly, unaudited pro forma consolidated financial information reflecting the results of operations of Go2Map has not been presented.
12. Zero Coupon Convertible Senior Notes
The Company completed a private placement on July 14, 2003 of $90 million principal amount of zero coupon convertible senior notes due July 2023, which resulted in net proceeds to the Company of approximately $87,350,000 after deduction of the initial purchaser’s discount of $2,250,000 and offering expenses of $400,000. The notes are a senior unsecured obligation of the Company and rank equally in right of payment with all of other unsecured and unsubordinated indebtedness of the Company. The notes do not pay any interest, have a zero yield to maturity, and are convertible into the Company’s common stock at a conversion price of $44.76 per share, subject to adjustment for dividends, distributions, and upon the occurrence of certain other events. Each $1,000 principal of the notes is initially convertible into 22.3414 shares of common stock of the Company. Each holder of the notes will have the right, at the holder’s option, to require the Company to repurchase all or any portion of the principal amount of the holder’s notes on July 14 in 2007, 2013 and 2018 at a price equal to 100% of the outstanding principal amount. The Company may also redeem all or a portion of the notes for cash at any time on or after July 14, 2008 at 100% of the principal amount of the notes if the closing price of its common stock for each of the 30 consecutive trading days prior to such time was at least 130% of the conversion price or at such time at least 90% of the initial aggregate principal amount of the notes have been converted, repurchased or redeemed. In addition, upon a change of control event, each holder of the notes has the right to require the Company to repurchase some or all of its notes at a repurchase price equal to 100% of the principal amount of the notes.
For the year ended December 31, 2006, the Company early redeemed from the market a portion of its zero coupon convertible senior notes at a discount for $15,000,000 in aggregate face value, after deducting the related portion of unamortized offering cost.
As of the end of the notification period associated with the July 14, 2007 repurchase date, note holders had exercised their right to require the Company to repurchase such notes in an aggregate principal amount of $58.5 million. The Company repurchased such notes on July 16, 2007. In November 2007, the majority of remaining note holders with $1,250,000 in face amount of convertible notes exercised their right to convert their notes to the Company’s common stock at a conversion price of $44.76 per share.
As of December 31, 2007, the outstanding balance of zero coupon convertible senior notes was $6,000.
13. China Contribution Plan
The Company’s subsidiaries in China participate in a government-mandated multi-employer defined contribution plan pursuant to which certain retirement, medical and other welfare benefits are provided to employees. Chinese labor regulations require the Company’s subsidiaries to pay to the local labor bureau a monthly contribution at a stated contribution rate based on the monthly basic compensation of qualified employees. The relevant local labor bureau is responsible for meeting all retirement benefit obligations; the Company has no further commitments beyond its monthly contribution. During the years ended December 31, 2007, 2006 and 2005, the Company contributed a total of $11,202,000, $7,448,000 and $4,820,000, respectively, to these funds.
14. Profit Appropriation
Pursuant to the laws applicable to China’s Foreign Investment Enterprises, each of the Company’s subsidiaries in China must make appropriations from its after-tax profit to non-distributable reserve funds as determined by the Board of Directors. These reserve funds include a (i) general reserve, (ii) enterprise expansion fund and (iii) staff bonus and welfare fund. The general reserve fund requires annual appropriations of 10% of after-tax profit (as determined under PRC GAAP) until these reserves equal 50% of the amount of paid-in capital; the other fund appropriations are at the Company’s discretion.
Since Beijing Sohu Interactive Software Co., Ltd (“Sohu Software”), Go2Map Software (Beijing) Co., Ltd (“Go2Map Software”) and Beijing Sogou Technology Development Co., Ltd (“Sogou Technology”) under PRC GAAP, are either in an accumulated loss position or with loss in year of 2007, no appropriations have been made to the general reserve fund for the year ended December 31, 2007.
For the year ended December 31, 2005, Beijing Sohu New Era Information Technology Co., Ltd (“Sohu Era”) appropriated $1.7 million into the general reserve and the cumulative general reserve equal to 50% of its paid-in capital; therefore Sohu Era did not appropriate any additional reserve during 2006. In 2007, Sohu Era further made an appropriation of approximately $199,000 due to its increased paid-in capital as a result of reinvestment. For the year ended December 31, 2007, Beijing Sohu New Media Information Technology Co., Ltd (“Sohu Media”) and Beijing AmazGame Age Internet Technology Co., Ltd (“AmazGame Age”) made an appropriation of approximately $3.8 million and $1.1 million to the general reserve fund, respectively. Upon certain regulatory approvals and subject to certain limitations, the general reserve fund can be used to offset prior year losses, if any, and could be converted into paid-in capital of Sohu Era, Sohu Media, Sogou Technology and AmazGame Age for PRC GAAP and legal purposes. Other than the appropriations to the general reserve fund, the Company did not make any other appropriations for the years ended December 31, 2007 and 2006.
15. Concentration of Risks
The operations of the Company are substantially located in the PRC and accordingly, investing in the shares of the Company are subject to among others, the PRC’s political, economic and legal risks.
Substantially all of the Company’s wireless revenues for all periods presented are derived from providing wireless services. The Company relies on two major third party mobile network operators and their subsidiaries for the billing of and collection from mobile phone users. If the annual contracts with these operators were not renewed or were terminated, the Company’s wireless business could be adversely affected. As of December 31, 2007 and 2006, $4,823,000 and $7,139,000 of accounts receivable balances were ultimately due from mobile network operators for wireless services.
Financial instruments that potentially subject the Company to significant concentration of credit risk consist primarily of cash and cash equivalents. As of December 31, 2007, approximately 64% of the Company’s cash and cash equivalents were held in 10 financial institutions in mainland China, and 36% of the Company’s cash and cash equivalents were held by financial institutions in the United States, Singapore, or Hong Kong. Accounts receivable are typically unsecured, denominated in RMB, and derived from revenues earned from customers primarily located in the People’s Republic of China. The Company performs ongoing credit evaluations of its customers and, if necessary, maintains reserves for potential credit losses. Historically, such losses have been within management’s expectations.
16. Commitments and Contingencies
In March 2007, the Chinese government enacted the Corporate Income Tax Law, and promulgated related regulations, which were effective January 1, 2008. The Corporate Income Tax Law, among other things, imposes a unified income tax rate of 25% for both domestic and foreign invested enterprises. New technology enterprises will enjoy a favorable tax rate of 15%, but the qualifying criteria for a new technology enterprise under the Corporate Income Tax Law have not been released yet. Currently, there are divergent views on how the Corporate Income Tax Law will be implemented. The Company's ultimate applicable effective tax rate in 2008 and beyond will depend on many factors, including but not limited to whether certain of its legal entities will obtain an approval of their new technology enterprise status under the Corporate Income Tax Law, whether they can continue to enjoy the unexpired tax holidays and how the withholding tax on dividends will be applied. If any of Sohu Era, Sohu Media, Sogou Technology, AmazGame Age, Sohu Internet, Sogou Information and Gamease Age cannot obtain an approval on their new technology enterprise status under the Corporate Income Tax Law and/or cannot continue to enjoy the unexpired tax holidays or if the withholding tax on dividends is applied in a manner different from our understanding, our effective tax rate will be increased significantly. Please refer to Note 19 for details.
The Chinese market in which the Company operates poses certain macro-economic and regulatory risks and uncertainties. These uncertainties extend to the ability of the Company to operate an Internet business, and to conduct brand advertising, sponsored search, online game and wireless services in the PRC. Though the PRC has, since 1978, implemented a wide range of market-oriented economic reforms, continued reforms and progress towards a full market-oriented economy are uncertain. In addition, the telecommunication, information, and media industries remain highly regulated. Restrictions are currently in place and are unclear
with respect to which segments of these industries foreign owned entities, like the Company, may operate. The Chinese government may issue from time to time new laws or new interpretations on existing laws to regulate areas such as telecommunication, information and media. Regulatory risks also encompass the interpretation by the tax authorities of current tax laws and regulations, including the applicability of certain preferential tax treatments. The Company’s legal structure and scope of operations in China could be subjected to restrictions which could result in severe limits to the Company’s ability to conduct business in the PRC.
The Company’s sales, purchase and expense transactions are generally denominated in RMB and a significant portion of the Company’s assets and liabilities are denominated in RMB. The RMB is not freely convertible into foreign currencies. In China, foreign exchange transactions are required by law to be transacted only by authorized financial institutions. Remittances in currencies other than RMB by the Company’s subsidiaries in China may require certain supporting documentation in order to effect the remittance.
From time to time, the Company becomes subject to legal proceedings and claims in the ordinary course of our business, including claims of alleged infringement of trademarks, copyrights and other intellectual property rights in connection with the content published on our Websites. The Company provides for the amount of loss, if there is information available prior to issuance of the Company’s financial statements indicating that it is probable that a liability had been incurred at the date of the financial statements and the amount of loss can be reasonably estimated.
The Company has entered in certain sponsorship agreements, under which the Company is obliged to provide advertising services and Website construction, operation and maintenance services to third parties during the contract periods.
As of December 31, 2007, the Company had future minimum content and service purchase commitments of $12.4 million, $2.1 million and $149,000 for the years ended December 31, 2008, 2009 and 2010, respectively. As of December 31, 2007, the Company had made certain deposits into restricted bank accounts as guarantees to meet the requirements under those contracts.
As of December 31, 2007, the Company had future minimum rental lease payments of $1.1 million, $714,000 and $649,000 for the years ending December 31, 2008, 2009 and 2010, respectively, under various non-cancelable operating leases ending 2012. The Company recognized $529,000, $3.6 million and $3.2 million of rent expense for the years ended December 31, 2007, 2006 and 2005, respectively.
17. VIEs and Related Party Transactions
(a) VIEs
FIN 46R “Consolidation of Variable Interest Entities” requires a VIE to be consolidated by a company if that company is the primary beneficiary of that VIE.
To satisfy PRC laws and regulations, the Company conducts its Internet information, wireless and certain other businesses in the PRC via its VIEs. These VIEs are directly or indirectly owned by Dr. Charles Zhang (“Dr. Zhang”), the Company’s Chairman, Chief Executive Officer and a major shareholder, and certain employees of the Company. Capital for the VIEs is funded by the Company through loans provided to Dr. Zhang and those employees, and is initially recorded as loans to related parties. These loans are eliminated for accounting purposes with the capital of VIEs during consolidation.
Under contractual agreements with the Company, Dr. Zhang and other Sohu employees who are shareholders of the VIEs are required to transfer their ownership in these entities to the Company, if permitted by PRC laws and regulations, or, if not so permitted, to designees of the Company at any time to repay the loans outstanding. All voting rights of the VIEs are assigned to the Company, and the Company has the right to designate all directors and senior management personnel of the VIEs. Dr. Zhang and the other Sohu employees who are shareholders of the VIEs have pledged their shares in the VIEs as collateral for the loans. As of December 31, 2007, the aggregate amount of these loans was $11.4 million.
The following is a summary of the VIEs of the Company which had been consolidated under FIN 46R:
a) High Century
High Century was incorporated in the PRC in 2001 and engages in investment holding in the PRC on behalf of the Company. The registered capital of High Century is $4,595,000. Dr. Zhang and Li Wei, an employee of the Company, hold 80% and 20% interests in High Century, respectively.
b) Sohu Entertainment
Sohu Entertainment, formerly known as Hengda, was incorporated in the PRC in 2002 and engages in Internet access and wireless services in the PRC on behalf of the Company. The registered capital of Sohu Entertainment is $1,210,000. Originally, High Century and Li Wei held 80% and 20% interests in Sohu Entertainment, respectively. In November 2004, to further satisfy PRC regulations, High Century and Li Wei transferred their interests in Sohu Entertainment to Xin Wang (Belinda) and Wang Jianjun, each of whom was an employee of the Company. In July 2007, Wang Jianjun transferred all his interests in Sohu Entertainment to Deng Ye, an employee of the Company. As a result, Xin Wang (Belinda) and Deng Ye own 80% and 20% interests in Sohu Entertainment, respectively.
c) Sohu Internet
Sohu Internet was incorporated in the PRC in 2003 and engages in Internet information, wireless and advertising services in the PRC on behalf of the Company. The original registered capital was $605,000, and High Century and He Jinmei held 80% and 20% interests in Sohu Internet, respectively. In December 2003, Sohu Entertainment made a $605,000 investment in Sohu Internet. In April 2005, He Jinmei transferred all her interests in Sohu Internet to High Century, and High Century made a $1,208,000 additional investment in Sohu Internet. As a result, the registered capital is now $2,418,000, with High Century and Sohu Entertainment holding 75% and 25% interests, respectively.
d) Goodfeel
Goodfeel was incorporated in the PRC in 2001 and engages in value-added telecommunication services in the PRC. The registered capital of Goodfeel is $1,208,000. In May 2004, High Century and Sohu Internet acquired 73% and 27% interests in Goodfeel, respectively. In July 2004, High Century and Sohu Internet invested $613,000 and $473,000 in Goodfeel, respectively, so that High Century owned a 58.1% interest in Goodfeel with the remaining 41.9% interest owned by Sohu Internet. In October 2004, to further satisfy PRC regulations, High Century and Sohu Internet transferred their interests in Goodfeel to Deng Xiufeng and Zhou Jing, each of whom is an employee of the Company. In August 2007, Deng Xiufeng transferred all his interests in Goodfeel to Yue Guofeng, an employee of the Company. As a result, Yue Guofeng and Zhou Jing own 58.1% and 41.9% interests in Goodfeel, respectively.
e) Huohu
Huohu was incorporated in the PRC in 2005. Huohu engages in software and technology development for the online game business. The registered capital of Huohu is $121,000. Sohu Era and an employee of Huohu hold 75% and 25% interests in Huohu, respectively. The Company provided the employee with a non-interest bearing loan of $33,000 to finance his capital contribution to Huohu. The loan is repayable upon demand by the Company at any time or upon termination of the employment of the employee and can only be repaid through transfer of the employee’s shares in Huohu to Sohu Internet. Based on the arrangement between Sohu Era and the employee, Sohu Era is the sole and primary beneficiary of Huohu.
f) Tu Xing Tian Xia
Tu Xing Tian Xia was incorporated in the PRC in 1999 and engages in mapping services in the PRC. The registered capital of Tu Xing Tian Xia is $248,000. In May 2005, in connection with the Company’s acquisition of Go2Map, the Company designated High Century and Sohu Internet as its designees to purchase the outstanding registered capital of Tu Xing Tian Xia. As a result, High Century and Sohu Internet own 56.1% and 43.9% interests in Tu Xing Tian Xia, respectively.
g) Feng Yang Tian Lang
Feng Yang Tian Lang was incorporated in the PRC in 2005 and engages in advertising services in the PRC. The registered capital of Feng Yang Tian Lang is $248,000. Sohu Internet and High Century each holds a 50% interest in Feng Yang Tian Lang.
h) Sogou Information
Sogou Information was incorporated in the PRC in 2005 and engages in providing Internet information services in the PRC. The registered capital of Sogou Information is $2,480,000. Zhou Jing and Li Wei, each of whom is an employee of the Company, each owns a 50% interest in Sogou Information.
i) Guangzhou Interactive
Guangzhou Interactive was incorporated in the PRC in 2006 and engages in providing Internet information services in Guangdong Province. The registered capital of Guangzhou Interactive is $631,000. Sohu Internet and High Century each holds a 50% interest in Guangzhou Interactive. In January 2008, Guangzhou Interactive was liquidated.
j) Gamease Age
Gamease Age was incorporated in the PRC in August 2007 and engages in Internet information services. The registered capital of Gamease Age is $1,331,000. Wang Tao and Zhou Jing, each of whom is an employee of the Company, own 60% and 40% interests, respectively, in Gamease Age.
Pursuant to FIN 46R, High Century, Sohu Entertainment, Sohu Internet, Goodfeel, Huohu, Tu Xing Tian Xia, Feng Yang Tian Lang, Sogou Information, Guangzhou Interactive and Gamease Age are VIEs, of which the Company is the primary beneficiary. Accordingly, the VIEs have been consolidated in the Company’s financial statements. As of December 31, 2007 and 2006, the above VIEs have aggregated accumulated net profit of approximately $3.7 million and $8.0 million, respectively, and have been reflected in the consolidated financial statements.
(b) Related Party Transactions
The following table summarizes related party transactions during the years ended December 31, 2007, 2006 and 2005, respectively (in thousands):
* This investee ceased to be a related party of the Company starting September 1, 2007, when the Company disposed its equity investment. Accordingly, since then, transactions with this party are not regarded as related party transactions.
18. Shareholders’ Equity
(a) Stockholder Rights Plan
The Company adopted a stockholder rights plan (the “Plan”) in 2001. The Plan is designed to deter coercive takeover tactics, including the accumulation of shares in the open market or through private transactions, and to prevent an acquirer from gaining control of the Company without offering a fair and adequate price and terms to all of the Company’s stockholders. In general, the Plan vests stockholders of Sohu with rights to purchase preferred stock of the Company at a substantial discount from those securities’ fair market value upon a person or group acquiring without the approval of the Board of Directors more than 20% of the outstanding shares of common stock of the Company. Any person or group who triggers the purchase right distribution becomes ineligible to participate in the Plan, causing substantial dilution of such person or group’s holdings. The rights will expire on July 25, 2011.
(b) Treasury Stock
During the year ended December 31, 2007, the Company did not purchase any shares of its common stock. During the year ended December 31, 2006, the Company repurchased 690,580 shares of its common stock for total consideration at a $15 million, and during the year ended December 31, 2005, the Company repurchased 885,605 shares of its common stock for total consideration of $13.8 million including brokerage commission, to demonstrate confidence in the health and future prosperity of the Company. The shares repurchased by the Company are no longer outstanding, and are being held by the Company as treasury stock. Treasury stock is accounted for under the cost method.
(c) Stock Incentive Plan
The Company’s 2000 Stock Incentive Plan, including stock options and restricted stock units, provides for the issuance of up to 9,500,000 shares of common stock. The maximum term of any issued stock right is ten years from the grant date.
The Company has reserved 9,500,000 shares of new common stock for issuance under the Company’s 2000 Stock Incentive Plan. As of December 31, 2007, 1,066,419 shares were available for grant under the plan.
In accordance with SFAS 123(R), effective from January 1, 2006, all share-based payments to employees and directors are recognized in the financial statements based on their grant date fair values. The valuation provisions of SFAS 123(R) apply to new awards, to awards granted to employees and directors before the adoption of SFAS 123(R) whose related requisite services had not been provided, and to awards which were subsequently modified or cancelled. In March 2005, the SEC issued SAB 107 regarding the SEC’s interpretation of SFAS 123(R) and the valuation of share-based payments for public companies. The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
Estimates of fair value are not intended to predict actual future events or the value that ultimately will be realized by employees who receive equity awards, and subsequent events are not indicative of the reasonableness of the original estimates of fair value made by the Company under SFAS 123(R).
A summary of option activity under the Company’s 2000 Stock Incentive Plan as of December 31, 2007, and changes during the year then ended, is presented below:
The aggregate intrinsic value in the preceding table represents the total intrinsic value based on the Company’s closing stock price of $54.52 as of December 31, 2007.
The total intrinsic value of options exercised during the year ended December 31, 2007 was $19.7 million.
A summary of restricted stock unit activity under the Company’s 2000 Stock Incentive Plan as of December 31, 2007, and changes during the year then ended, is presented below:
The following table summarizes significant ranges of outstanding and exercisable options as of December 31, 2007:
As of December 31, 2007, there was $1.3 million of total unrecognized compensation cost related to options for which services had not been provided. That cost is expected to be recognized over a weighted average period of 0.68 year. The total fair value of options expensed during the years ended December 31, 2007 and 2006 were $2.7 million and $5.0 million, respectively.
As of December 31, 2007, there was $5.8 million of unrecognized compensation cost related to unvested restricted stock units, net of forecasted forfeitures. This amount is expected to be recognized over a weighted average period of 1.12 years. Total fair value of restricted stock units expensed during the years ended December 31, 2007 and 2006 were $6.1 million and $1.9 million, respectively.
There were no capitalized share-based compensation costs during the years ended December 31, 2007 and 2006.
During the year ended December 31, 2007, total cash received from the exercise of stock options amounted to $10.8 million.
19. Income Taxes
The Company is subject to taxes in the United States at 34% or 35%, depending upon taxable income levels. Certain of the Company’s subsidiaries are subject to taxes in Hong Kong at 17.5% and certain subsidiaries are subject to taxes in the People’s Republic of China.
Prior to January 1, 2008, the Company’s subsidiaries in China were governed by the Income Tax Law of the People’s Republic of China concerning Foreign Investment Enterprises and Foreign Enterprises and local income tax laws (the previous income tax laws and rules). Pursuant to the previous income tax laws and rules, wholly-owned foreign enterprises were subject to tax at a statutory rate of 33% (30% state income tax plus 3% local income tax), or 15% for certain technology enterprises, on PRC taxable income. Furthermore, new technology enterprises were exempted from Chinese state corporate income tax for three years, beginning with their first year of operations, and were entitled to a 50% tax reduction to a rate of 7.5% for the subsequent three years and 15% thereafter. During the year ended December 31, 2007, most operations of the Company in the PRC were subject to an applicable tax rate of 7.5% or were exempted from income tax as new technology enterprises.
In March 2007, the Chinese government enacted the Corporate Income Tax Law, and promulgated related regulations, which were effective January 1, 2008. The Corporate Income Tax Law, among other things, imposes a unified income tax rate of 25% for both domestic and foreign invested enterprises. New technology enterprises will still enjoy a favorable tax rate of 15%, but the qualifying criteria for a new technology enterprise under the Corporate Income Tax Law have not been released yet. The previous income tax laws and rules, which stipulated income tax rates for domestic and foreign invested enterprises at different rates, expired upon the effectiveness of the Corporate Income Tax Law.
The Corporate Income Tax Law provides a five-year transitional period for those entities established before March 16, 2007, which enjoyed a favorable income tax rate of less than 25% under the previous income tax laws and rules, to gradually change their rates to 25%. In addition, the Corporate Income Tax Law provides grandfather treatment for companies qualified as new technology enterprises
under the previous income tax laws and rules and established before March 16, 2007 if they continue in the period after January 1, 2008 to meet the criteria for new technology enterprises under the previous income tax laws and rules. The grandfather provision allows these enterprises to continue to enjoy their unexpired tax holiday under the previous income tax laws and rules.
The Corporate Income Tax Law also imposes a 10% withholding income tax for dividends distributed by a foreign invested enterprise to its immediate holding company outside China, which were exempted under the previous income tax laws and rules. A lower withholding tax rate will be applied if there is a tax treaty arrangement between mainland China and the jurisdiction of the foreign holding company. Holding companies in Hong Kong, for example, will be subject to a 5% rate. Most of our China-based subsidiaries, Sohu Era, Sohu Media, Sohu Software, Sogou Technology, Go2Map Software and AmazGame Age are invested by immediate foreign holding companies in Hong Kong, except for Sogou Technology. All of these foreign invested enterprises will be subject to the withholding tax on January 1, 2008. Since we intend to reinvest our earnings to further expand our businesses in mainland China, our foreign invested enterprises do not intend to declare dividends to their immediate foreign holding companies in the foreseeable future. Accordingly, as of December 31, 2007, we have not recorded any withholding tax on the retained earnings of our foreign invested enterprises in China.
Currently, there are divergent views on how the Corporate Income Tax Law will be implemented. The Company's ultimate applicable effective tax rate in 2008 and beyond will depend on many factors, including but not limited to whether certain of its legal entities will obtain an approval of their new technology enterprise status under the Corporate Income Tax Law, whether they can continue to enjoy the unexpired tax holidays and how the withholding tax on dividends will be applied. If any of Sohu Era, Sohu Media, Sogou Technology, AmazGame Age, Sohu Internet, Sogou Information and Gamease Age cannot obtain an approval on their new technology enterprise status under the Corporate Income Tax Law and/or cannot continue to enjoy the unexpired tax holidays or if the withholding tax on dividends is applied in a manner different from our understanding, our effective tax rate will be increased significantly.
Income before income tax expense of $36.4 million, $28.3 million and $31.1 million for 2007, 2006 and 2005 mainly represented the China income. Income tax related to China income of 2007 is $1.5 million. This mainly resulted from taxable income of Sohu Era, a subsidiary of Sohu with applicable tax rate of 7.5% for the year of 2007. During the years ended December 31, 2007, 2006 and 2005, income taxes paid were $1,292,000, $4,000 and $21,000, respectively.
The combined effects of the income tax expense exemption and reduction available to us are as follows (in thousands, except per share data):
The following is a reconciliation between the U.S. federal statutory rate and the Company’s effective tax rate:
Significant components of the Company’s deferred tax assets and liabilities consist of the following (in thousands):
As of December 31, 2007, the Company had federal net operating loss (“NOL”) of approximately $38 million available to offset against future federal income tax liabilities. The U.S. NOL will expire beginning 2020. The PRC NOL will expire beginning 2008.
The Company uses the short-cut method to pool its windfall tax benefit as prescribed by FASB Staff Position No. FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards.
The Company does not provide for United States federal income taxes or tax benefits on the undistributed earnings or losses of its international subsidiaries or VIEs because earnings are reinvested and, in the opinion of management, will continue to be reinvested indefinitely. As of December 31, 2007 and 2006, these cumulative undistributed earnings are included in consolidated retained earnings on the balance sheet and amounted to $124 million and $90.6 million, respectively. An estimated $42.2 million and $30.8 million in U.S. income and foreign withholding taxes would be due if these earnings were remitted as dividends, after payment of all deferred taxes as of December 31, 2007 and 2006.
20. Financial Instruments
The carrying amount of the Company’s cash and cash equivalents approximates their fair value due to the short maturity of those instruments. The carrying value of receivables and payables approximated their market value based on their short-term maturities. The investments in marketable debt securities are reported at fair market value as of the balance sheet dates. The fair market value for the zero coupon convertible senior notes was $6,000 and $57.8 million as of December 31, 2007 and 2006, respectively.
21. Net Income per Share
The following table sets forth the computation of basic and diluted net income per share for the years indicated (in thousands except per share data):
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
SOHU.COM INC.
CONDENSED BALANCE SHEETS
(in thousands)
SOHU.COM INC.
CONDENSED STATEMENTS OF OPERATIONS
(in thousands)
SOHU.COM INC.
CONDENSED STATEMENTS OF CASH FLOWS
(in thousands)
NOTES TO SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF SOHU.COM INC.
1. The condensed financial statements of Sohu.com Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America except for accounting of the Company’s subsidiaries and VIEs and certain footnote disclosures as described below.
The Company records its investment in subsidiaries under the equity method of accounting as prescribed in APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” Such investment and long-term loans to subsidiaries are presented on the balance sheet as interests in subsidiaries and VIEs and the profit of the subsidiaries is presented as equity in profit of subsidiaries and VIEs on the statement of operations.
For VIEs where the Company is the primary beneficiary, the amount of the Company’s investment is included on the balance sheet as interests in subsidiaries and VIEs and the profit or loss of the VIEs is included in equity in profit of subsidiaries and VIEs on the statement of operations.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. The footnote disclosures contain supplemental information relating to the operations of the Company and, as such, these statements should be read in conjunction with the notes to the Consolidated Financial Statements of the Company.
2. As of December 31, 2007 and 2006, there were no material contingencies, significant provisions of long-term obligations, mandatory dividend or redemption requirements of redeemable stocks or guarantees of the Company, except for those which have been separately disclosed in the Consolidated Financial Statements, if any.
3. For each of the years in the three-year period ended December 31, 2007, there were no cash dividends paid to the Company by its consolidated subsidiaries, VIEs or associate.
4. Related party transactions
a) During the year ended December 31, 2007, interest of $5.0 million was principalized at a 6.0% interest rate per annum, and the Company did not grant other additional long-term loans to Sohu.com Limited. During the year ended December 31, 2006, interest of $4.6 million was principalized at a 6.2% interest rate per annum.
b) As of December 31, 2007, the long-term loans to subsidiaries bore an interest rate of 4.9% to 6.2% per annum. As of December 31, 2007, the maturity dates for the long-term loans to subsidiaries are one to four years. For the years ended December 31, 2007 and 2006, the interest income from the loan amounted to $5.3 million and $5.0 million, respectively.
EXHIBIT INDEX