[May 09, 2013] SOHU COM INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Tweet (Edgar Glimpses Via Acquire Media NewsEdge) As used in this report, references to "us," "we," "our," "our company," "our group," "Sohu" and "Sohu.com" are to Sohu.com Inc. and, except where the context requires otherwise, our wholly-owned and majority owned subsidiaries and variable interest entities ("VIEs"), Sohu.com Limited, Sohu.com (Hong Kong) Limited ("Sohu Hong Kong"), All Honest International Limited, Sohu.com (Game) Limited ("Sohu Game"),Go2Map Inc., Sohu.com (Search) Limited, Sogou Inc., Sogou (BVI) Limited, Sogou Hong Kong Limited, Vast Creation Advertising Media Services Limited ("Vast Creation"), Fox Video Investment Holding Limited ("Video Investment"), Fox Video Limited ("Sohu Video"), Fox Video (HK) Limited ("Video HK"), Beijing Sohu New Era Information Technology Co., Ltd. ("Sohu Era"), Beijing Sohu Software Technology Co., Ltd. ("New Software"), Beijing Fire Fox Digital Technology Co., Ltd. ("Beijing Fire Fox," also known as Beijing Huohu Digital Technology Co., Ltd., or "Huohu"), Beijing Sohu Interactive Software Co., Ltd. ("Sohu Software"), Go2Map Software (Beijing) Co., Ltd. ("Go2Map Software"), Beijing Sogou Technology Development Co., Ltd. ("Sogou Technology"), Beijing Sogou Network Technology Co., Ltd ("Sogou Network"), Fox Information Technology (Tianjin) Limited ("Video Tianjin"), Beijing Sohu New Media Information Technology Co., Ltd. ("Sohu Media"), Beijing Focus Time Advertising Media Co., Ltd. ("Focus Time"), Beijing Sohu New Momentum Information Technology Co., Ltd. ("Sohu New Momentum"), Beijing Century High Tech Investment Co., Ltd. ("High Century"), Beijing Sohu Entertainment Culture Media Co., Ltd. ("Sohu Entertainment," formerly known as Beijing Hengda Yitong Internet Technology Development Co., Ltd., or "Hengda"), Beijing Sohu Internet Information Service Co., Ltd. ("Sohu Internet"), Beijing GoodFeel Information Technology Co., Ltd. ("GoodFeel"), Beijing Sogou Information Service Co., Ltd. ("Sogou Information"), Beijing 21 East Culture Development Co., Ltd. ("21 East Beijing"), Beijing Sohu Donglin Advertising Co., Ltd.("Donglin"), Beijing Pilot New Era Advertising Co., Ltd. ("Pilot New Era"), Beijing Focus Yiju Network Information Technology Co., Ltd. ("Focus Yiju"), Beijing Yi He Jia Xun Information Technology Co., Ltd. ("Yi He Jia Xun"), Beijing Zhi Hui You Information Technology Co., Ltd. ("Zhi Hui You"), Tianjin Jinhu Culture Development Co., Ltd. ("Tianjin Jinhu") and our independently-listed majority-owned subsidiary Changyou.com Limited ("Changyou," formerly known as TL Age Limited) as well as the following direct and indirect subsidiaries and VIEs of Changyou: Changyou.com HK Limited ("Changyou HK," formerly known as TL Age Hong Kong Limited), Changyou.com Webgame (HK) Limited ("Changyou HK Webgame"), Changyou.com Gamepower (HK) Limited ("Changyou HK Gamepower"), ICE Entertainment (HK) Limited ("ICE HK"), Changyou.com (US) Inc. (formerly known as AmazGame Entertainment (US) Inc.), Changyou.com (UK) Company Limited ("Changyou UK"), ChangyouMy Sdn. Bhd ("Changyou Malaysia"), Changyou.com Korea Limited ("Changyou Korea"), Changyou.com India Private Limited ("Changyou India"), Changyou B L M H ZMETLER T CARET L M TED RKET ("Changyou Turkey"), Kylie Enterprises Limited, 7Road.com Limited ("7Road"), 7Road.com HK Limited ("7Road HK"), Beijing AmazGame Age Internet Technology Co., Ltd. ("AmazGame"), Beijing Changyou Gamespace Software Technology Co., Ltd. ("Gamespace"), ICE Information Technology (Shanghai) Co., Ltd. ("ICE Information"), Beijing Yang Fan Jing He Information Consulting Co., Ltd. ("Yang Fan Jing He"), Shanghai Jingmao Culture Communication Co., Ltd. ("Shanghai Jingmao"), Shanghai Hejin Data Consulting Co., Ltd. ("Shanghai Hejin"), Beijing Changyou Jingmao Film & Culture Communication Co., Ltd. ("Beijing Jingmao"), Beijing Gamease Age Digital Technology Co., Ltd. ("Gamease"), Beijing Guanyou Gamespace Digital Technology Co., Ltd. ("Guanyou Gamespace"), and Shanghai ICE Information Technology Co., Ltd.("Shanghai ICE"), Shenzhen 7Road Network Technologies Co., Ltd.("7Road Technology"), Shenzhen 7Road Technology Co., Ltd. ("Shenzhen 7Road"), and these references should be interpreted accordingly. Unless otherwise specified, references to "China" or "PRC" refer to the People's Republic of China and do not include the Hong Kong Special Administrative Region, the Macau Special Administrative Region or Taiwan. This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, without limitation, statements regarding our expectations, beliefs, intentions or future strategies that are signified by the words "expect," "anticipate," "intend" ,"believe," or similar language. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our business and financial performance are subject to substantial risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements. In evaluating our business, you should carefully consider the information set forth under the heading "Risk Factors" in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2012 filed with the Securities and Exchange Commission ("SEC") on February 28, 2013, as updated by Part II Item 1A of this report. Readers are cautioned not to place undue reliance on these forward-looking statements. OVERVIEW Sohu (NASDAQ: SOHU) is a leading Chinese online media, search, gaming, community and mobile service group. We operate one of the most comprehensive matrices of Chinese language content and services, and we developed and operate one of the most popular massively multiplayer online games and two popular Web games in China. Substantially all of our operations are conducted through our indirect wholly-owned and majority-owned China-based subsidiaries and variable interest entities (collectively the "Sohu Group"). -37--------------------------------------------------------------------------------- Table of Contents Our businesses consist of the online advertising business, which consists of the brand advertising business as well as the search and others business, the online game business, the wireless business and the others business, among which online advertising and online games are our core businesses. Factors and Trends Affecting our Business According to a report issued by the China Internet Network Information Center ("CNNIC"), the total number of Internet users in China had reached 564 million by December 31, 2012. The CNNIC report stated that the number of mobile Internet users in China had reached 420 million, indicating that mobile Internet has become the top channel for Internet users to access Websites in China, exceeding the number of desktop computer Internet users in China by 22 million. We believe that this large and expanding user base will continue to provide significant opportunities to expand our product offerings and to explore new revenue streams. In China, online video is a top Internet application, with over 370 million users by December 31, 2012, according to CNNIC. We expect that brand advertisers will continue to allocate more advertising dollars to online video in order to exploit this growing market. In early 2012, to better employ market opportunities, we made a strategic decision to set up a dedicated advertising sales force for our online video business. In the fourth quarter of 2012, while we continue the restructuring of our video division, we completed the establishment of a dedicated video sales team and the transition was smooth. This new team is now fully functioning, and was able to start 2013 with sequential revenue growth in a traditionally slow first quarter. We expect growth in video advertising revenue to accelerate in 2013. Our search and others business continued to grow, which was attributable to the growth of pay-for-click services, as well as online marketing services on the Sogou Web Directory. We expect our search and others business to sustain healthy revenue growth through the remainder of 2013. We continue to be pleased with and optimistic regarding the growth and profitability of our online game business. We believe that our strong performance in the first quarter reflects the growth of the China online game industry as more people play games on PCs, on Internet browsers and on mobile devices. We also believe that it reflects the ongoing strength of our online games content as we are constantly updating our games based on user feedback, which helps to extend the popularity of our games in China. We also have made a successful transition from a pure-play game developer to a broad spectrum gaming company offering multiple types of games on different devices and owning the leading game information portal, 17173.com, in China. On May 1, 2013, Changyou entered into a definitive agreement to acquire all of the ordinary shares of 7Road.com Limited ("7Road") held by the noncontrolling shareholders, representing 28.074% of the outstanding share capital of 7Road, for aggregate fixed cash consideration of approximately $78 million. Following the closing of the acquisition, 7Road will be an indirect wholly-owned subsidiary of Changyou, and Changyou's VIE Gamease will be the sole shareholder of 7Road's VIE Shenzhen 7Road Technology Co., Ltd ("Shenzhen 7Road"). Summary of Our Business Online Advertising Business Brand Advertising Business Our brand advertising business offers to our users, over our matrices of Chinese language Web content and services, various products and services (such as free of charge content, including news, video, interactive community, and other competitive Internet services) across multiple internet-enabled devices, such as PCs, mobile phones and tablets. The majority of our products and services are provided on the following platforms: • Sohu.com, a leading mass portal and media destination; • Focus.cn, a top real estate Website; and • 17173.com, a leading game information portal. Since December 15, 2011, 17173.com has been owned and operated by our majority-owned subsidiary Changyou.com Limited ("Changyou"). Search and Others Business Our search and others business, provided by our search subsidiary Sogou Inc. ("Sogou"), primarily offers customers pay-for-click services, as well as online marketing services on the Sogou Web Directory. Pay-for-click services enable our advertisers' promotional links to be displayed on Sogou search result pages and Sogou Website Alliance members' Websites where the links are relevant to the subject and content of such Web pages. Both pay-for-click services and online marketing services on the Sogou Web Directory expand distribution of our advertisers' Website links or advertisements by leveraging traffic on Sogou Website Alliance members' Websites. -38--------------------------------------------------------------------------------- Table of Contents Online Game Business Our online game business is conducted via Changyou, a leading online game developer and operator in China. Changyou engages in the development, operation and licensing of online games, including massively multiplayer online games ("MMOGs") and Web games. Changyou developed and operates Tian Long Ba Bu ("TLBB"), which is one of the most popular MMOGs in China. 7Road, which was an indirect majority-owned subsidiary of Changyou as of March 31, 2013 and will be an indirect wholly-owned subsidiary after the closing of the acquisition discussed under the heading "Business Restructuring" below, jointly operates its own Web games DDTank and Wartune (also known as "Shen Qu") with third-party joint operators, and also directly operates Wartune through its Website. DDTank and Wartune are two popular Web games in China. For the first quarter of 2013, more than 70% of the revenues of Changyou's online game business were derived from TLBB. We depend on Changyou for a significant portion of our revenues, net income, and operating cash flow. For the first quarter of 2013, Changyou's online game revenues were $167.4 million, which represented 54% of our total revenues. Net income contributed by Changyou for the quarter was $88.3 million, which represented 152% of our total net income. Wireless Business Our wireless business offers mobile related services through different types of wireless products to mobile phone users. The wireless products mainly consist of short messaging services ("SMS"), interactive voice response ("IVR"), mobile games, mobile video and Ring Back Tone ("RBT"). A majority of the content is purchased from third party content providers. Others Business Our others business are primarily generated from our business of offering Internet value-added services ("IVAS") with respect to Web games developed by third-party developers under revenue-sharing arrangements with the developers, our offering cinema advertisement slots to be shown in theaters before the screening of movies, and our sub-licensing of licensed video content to third parties. Business Restructuring 7Road Transactions On May 11, 2011, Changyou, through its VIE Gamease, acquired 68.258% of the equity interests of Shenzhen 7Road and began to consolidate Shenzhen 7Road's financial statements on June 1, 2011. Effective June 26, 2012, Shenzhen 7Road was reorganized into a Cayman Islands holding company structure where Changyou holds a direct ownership interest in 7Road through Changyou's subsidiary Changyou.com Webgame (HK) Limited, and Shenzhen 7Road is a VIE of 7Road. On June 21, 2012, Mr. Kai Cao, who was then 7Road's Chief Executive Officer, surrendered to 7Road, without consideration, ordinary shares of 7Road representing 5.1% of the then outstanding ordinary shares of 7Road. As a result, the noncontrolling interest decreased to 28.074% of 7Road and the Group's interest in 7Road increased to 71.926%. When we discuss 7Road and Shenzhen 7Road in this report, we treat the reorganization as if it had been effective upon Changyou's initial acquisition of the equity interests of Shenzhen 7Road. On May 1, 2013, Changyou entered into a definitive agreement to acquire all of the ordinary shares of 7Road held by the noncontrolling shareholders, representing 28.074% of the outstanding share capital of 7Road, for aggregate fixed cash consideration of approximately $78 million. Following the closing of the acquisition, 7Road will be an indirect wholly-owned subsidiary of Changyou, and Changyou's VIE Gamease will be the sole shareholder of 7Road's VIE Shenzhen 7Road. Effective with Changyou's entering into the definitive acquisition agreement, Mr. Dewen Chen, Changyou's President, was appointed as the Chairman and acting Chief Executive Officer of 7Road, and Mr. Kai Cao resigned as a director and as Chief Executive Officer of 7Road. Upon the closing of the acquisition, the former noncontrolling shareholders' existing non-compete covenants with Changyou will be terminated, and an agreement will take effect under which the former noncontrolling shareholders agree, for a period of two years after the closing, to not solicit or hire existing employees of 7Road. The acquisition is expected to close by May 31, 2013, subject to regulatory approvals and customary closing conditions specified in the definitive acquisition agreement. 17173 Transaction On December 15, 2011, we closed the sale to Changyou of certain assets associated with the business of 17173.com (the "17173 Business") for fixed cash consideration of $162.5 million. After the closing of the sale, we continued to consolidate the results of operations of the 17173 Business in our consolidated financial statements. -39- -------------------------------------------------------------------------------- Table of Contents Sogou Transactions On October 22, 2010, Sogou sold 24.0 million, 14.4 million and 38.4 million, respectively, of its newly-issued Series A Preferred Shares to Alibaba Investment Limited ("Alibaba"), a private investment subsidiary of Alibaba Group Holding Limited, China Web Search (HK) Limited ("China Web"), an investment vehicle of Yunfeng Fund, LP, and Photon Group Limited ("Photon"), the investment fund of Sohu's Chairman and Chief Executive Officer Dr. Charles Zhang, for $15 million, $9 million, and $24 million, respectively. On June 29, 2012, Sohu purchased the 24.0 million Sogou Series A Preferred Shares held by Alibaba for fixed cash consideration of $25.8 million. As of March 31, 2013, the Sohu Group held 70% of the combined total of Sogou's outstanding ordinary shares and Series A Preferred Shares. As we are Sogou's controlling shareholder, we continue to consolidate Sogou in our consolidated financial statements, but recognize noncontrolling interest reflecting economic interest held by shareholders other than us. Changyou Transactions On April 7, 2009, Changyou completed an initial public offering of its ADSs on the NASDAQ Global Select Market under the symbol "CYOU." Each of Changyou's ADS represents two ordinary shares. After the completion of Changyou's initial public offering, as we are Changyou's controlling shareholder, Changyou's financial results have been consolidated into ours for all periods presented. As of March 31, 2013, we held approximately 68% of the combined total of Changyou's outstanding ordinary shares and controlled approximately 81% of the total voting power in Changyou. Therefore, we consolidate Changyou in our consolidated financial statements but recognize noncontrolling interest reflecting shares held by shareholders other than us. CRITICAL ACCOUNTING POLICIES AND MANAGEMENT ESTIMATES Our discussion and analysis of our financial condition and results of operations relates to our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an 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. Identified below are the accounting policies that reflect our more significant estimates and judgments, and those that we believe are the most critical to fully understanding and evaluating our consolidated financial statements. Basis of Consolidation and Recognition of Noncontrolling Interest Our consolidated financial statements include the accounts of Sohu.com Inc. and its direct and indirect wholly-owned and majority-owned subsidiaries and consolidated variable interest entities ("VIEs"). All intercompany transactions are eliminated. We have adopted the guidance of accounting for VIEs, which requires VIEs to be consolidated by the primary beneficiary of the entity. For the consolidated VIEs, our management made evaluations of the relationships between us and our VIEs and the economic benefit flow of contractual arrangements with the VIEs. In connection with such evaluation, management also took into account the fact that, as a result of such contractual arrangements, we control the shareholders' voting interests in these VIEs. As a result of such evaluation, management concluded that we are the primary beneficiary of our consolidated VIEs. We have one VIE that is not consolidated by us, since we are not the primary beneficiary. Noncontrolling interests are recognized to reflect the portion of the equity of majority-owned subsidiaries and VIEs which is not attributable, directly or indirectly, to the controlling shareholder. Currently, the noncontrolling interests in our consolidated financial statements primarily consist of noncontrolling interests for Changyou and Sogou. Noncontrolling Interest for Changyou To reflect the economic interest in Changyou held by shareholders other than Sohu ("noncontrolling shareholders"), Changyou's net income attributable to these noncontrolling shareholders is recorded as noncontrolling interest in our consolidated statements of comprehensive income, based on their share of the economic interests in Changyou. Changyou's cumulative results of operations attributable to these noncontrolling shareholders, along with changes in shareholders' equity, adjustment for share-based compensation expense in relation to those share-based awards which are unvested and vested but not yet settled and adjustment for changes in Sohu's ownership in Changyou from Sohu's purchase of Changyou ADSs, are recorded as noncontrolling interest in our consolidated balance sheets. -40- -------------------------------------------------------------------------------- Table of Contents Noncontrolling Interest for Sogou To reflect the economic interest in Sogou held by shareholders other than Sohu ("noncontrolling shareholders"), Sogou's net income /loss attributable to these noncontrolling shareholders is recorded as noncontrolling interest in Sohu's consolidated statements of comprehensive income. Sogou's cumulative results of operations attributable to these noncontrolling shareholders, along with changes in shareholders' equity /(deficit) and adjustment for share-based compensation expense in relation to those share-based awards which are unvested and vested but not yet settled and noncontrolling shareholders' investments in Series A Preferred Shares are accounted for as a noncontrolling interest classified as permanent equity in our consolidated balance sheets, as redemption of the noncontrolling interest is solely within our control. These treatments are based on the terms governing investment by the noncontrolling shareholders in the Series A Preferred Shares of Sogou (the "Sogou Series A Terms"), the terms of Sogou's restructuring, and Sohu's purchase of Sogou Series A Preferred Shares from Alibaba. By virtue of these terms, as Sogou has been losing money since its restructuring, the net losses have been and will be allocated in the following order: (i) net losses were allocated to ordinary shareholders until their basis in Sogou decreased to zero; (ii) additional net losses will be allocated to holders of Sogou Series A Preferred Shares until their basis in Sogou decreases to zero; and (iii) further net losses will be allocated between ordinary shareholders and holders of Sogou Series A Preferred Shares based on their shareholding percentage in Sogou. Any subsequent net income from Sogou will be allocated in the following order: (i) net income will be allocated between ordinary shareholders and holders of Sogou Series A Preferred Shares based on their shareholding percentage in Sogou until their basis in Sogou increases to zero; (ii) additional net income will be allocated to holders of Sogou Series A Preferred Shares to bring their basis back; (iii) further net income will be allocated to ordinary shareholders to bring their basis back; and (iv) further net income will be allocated between ordinary shareholders and holders of Sogou Series A Preferred Shares based on their shareholding percentage in Sogou. Segment Reporting Our segments are business units that offer different services and are reviewed separately by the chief operating decision maker ("CODM"), or the decision making group, in deciding how to allocate resources and in assessing performance. Our CODM is the Chief Executive Officer. There are five segments in the Sohu Group, consisting of brand advertising, Sogou (which mainly consists of the search and others business), Changyou (which mainly consists of the online game business), wireless and others. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. The recognition of revenues involves certain management judgments. The amount and timing of our revenues could be materially different for any period if management made different judgments or utilized different estimates. Under ASC 845, barter trade transactions from which physical goods or services (other than advertising services) are received in exchange for advertising services should be recorded based on the fair values of the goods and/or services received. For a barter transaction involving online advertising services, we recognize revenue and expense at fair value only if the fair value of the advertising services surrendered /received in the transaction is determinable. For our advertising-for-advertising barter transactions, the fair value of the advertising surrendered /received is not determinable, so no revenue from advertising-for-advertising barter transactions is recognized. Online Advertising Revenues Online advertising revenues include revenues from brand advertising services as well as search and others services. We recognize gross revenue for the amount of fees we receive from our advertisers. Determining whether revenue should be reported gross or net is based on an assessment of various factors. The primary factor is whether we are acting as the principal in offering services to the customer or whether we are acting as an agent in the transaction. Whether we are serving as principal or agent in a transaction is judgmental in nature and is determined by evaluating the terms of the arrangement. Our revenues from online advertising services are recognized on a gross basis as we have the primary responsibility for fulfillment and acceptability. These revenues are recognized after deducting agent rebates paid to advertising agencies and applicable taxes and /or related surcharges. -41- -------------------------------------------------------------------------------- Table of Contents Before September 1, 2012, our online advertising revenues were subject to PRC business tax ("Business Tax"). Our online advertising revenues were recognized after deducting agent rebates and applicable Business Tax and related surcharges. Business Tax is imposed primarily on revenues from the provision of taxable services and is calculated by multiplying the applicable tax rate by gross revenue. Effective September 1, 2012, the PRC Ministry of Finance and the State Administration of Taxation launched a Business Tax to Value Added Tax ("VAT") Transformation Pilot Program ("Pilot Program") for certain industries in eight regions, including Beijing and Tianjin. VAT payable on goods sold or taxable labor services provided by a general VAT taxpayer for a taxable period is the net balance of the output VAT for the period after crediting the input VAT for the period. Hence, the amount of VAT payable does not result directly from output VAT generated from goods sold or taxable labor services provided. With the adoption of the Pilot Program, our online advertising revenues are subject to VAT. Our online advertising revenues are now recognized after deducting agent rebates and net of VAT and related surcharges. Brand Advertising Revenues Business Model Currently the brand advertising business has two main types of pricing models, consisting of the Fixed Price Model and the Cost Per Impression ("CPM") pricing model. Under the Fixed Price Model, a contract is signed to establish a fixed price for the advertising services to be provided. Under the CPM pricing model, the total contract amount for the advertising services is not fixed. Instead, a fixed price is stated for each qualifying display. Advertisers using the CPM pricing model pay us based on the number of qualifying displays of their advertisements appearing on our Websites, and we recognize as revenue the fees charged to advertisers each time their advertisements are displayed on the Websites, on the condition that each display meets certain selected criteria imposed by advertisers. We provide advertisement placements to our advertisers on our different Website channels and in different formats, which can include, among other things, banners, links, logos, buttons, full screen, pre-roll, post-roll, and mid-roll video screens, as well as pause video screens. Revenue Recognition For brand advertising revenue recognition, prior to entering into contracts, we make a credit assessment of the customer to assess the collectability of the contract. For those contracts for which the collectability is determined to be reasonably assured, we recognize revenue when all revenue recognition criteria are met. For those contracts for which the collectability is determined not to be reasonably assured, we recognize revenue only when the cash was received and all other revenue recognition criteria are met. Before 2011, since almost all of the elements were delivered within one calendar quarter, we treated all elements of advertising contracts as one single unit of accounting for revenue recognition purposes. Commencing January 1, 2011, in accordance with ASU No.2009 -13, we treat advertising contracts with multiple deliverable elements as separate units of accounting for revenue recognition purposes and to recognize revenue on a periodic basis during the contract when each deliverable service is provided. Since the contract price is for all deliverables, we allocate the arrangement consideration to all deliverables at the inception of the arrangement on the basis of their relative selling prices. Since the number of advertising contracts that covered more than one quarter and the revenues from advertising contracts that covered more than one quarter were immaterial compared to the total advertising contracts, the impact of adoption of ASU No.2009-13 to us is immaterial. Search and Others Revenues Search and others services mainly include pay-for-click services, as well as online marketing services on the Sogou Web Directory. Pay-for-click Services Pay-for-click services are services that enable our advertisers' promotional links to be displayed on Sogou search result pages and Sogou Website Alliance members' Websites where the links are relevant to the subject and content of such Web pages. For pay-for-click services, we introduce Internet users to our advertisers through our auction based pay-for-click systems and charge advertisers on a per click basis when the users click on the displayed links. Revenue for pay-for-click services is recognized on a per click basis when the users click on the displayed links. Online Marketing Services on the Sogou Web Directory Online marketing services on the Sogou Web Directory mainly consist of displaying advertiser Website links on the Web pages of the Sogou Web Directory. The Sogou Web Directory is a Chinese Web directory navigation site which serves as a key access point to popular and preferred Websites and applications. Revenue for online marketing services on the Sogou Web Directory is normally recognized on a straight-line basis over the contract period, provided our obligations under the contract have been met and all revenue recognition criteria have been met. -42- -------------------------------------------------------------------------------- Table of Contents Sogou Website Alliance Both pay-for-click services and online marketing services on the Sogou Web Directory expand distribution of advertisers' Website links or advertisements by leveraging traffic on Sogou Website Alliance members' Websites. We recognize gross revenue for the amount of fees we receive from advertisers. Payments made to Sogou Website Alliance members are included in cost of search and others revenues as traffic acquisition costs. Determining whether revenue should be reported gross or net is based on an assessment of various factors. The primary factor is whether we are acting as the principal in offering services to the customer or we are acting as an agent in the transaction. For pay-for-click services we recognize gross revenue, as we have the primary responsibility for fulfillment and acceptability. Whether we are serving as principal or agent in a transaction is judgmental in nature and is determined by evaluating the terms of the arrangement. We pay Sogou Website Alliance members based on either revenue-sharing arrangements, under which we pay a percentage of pay-for-click revenues generated from clicks by users of their properties, or on a pre-agreed unit price. Online Game Revenues Our online game revenues are generated from MMOG operations revenues, Web game revenues and overseas licensing revenues. MMOG operations revenues Revenues are recorded net of applicable Business Tax, discounts and rebates to distributors. Online game revenues from Changyou's current MMOG operations are earned by providing online services to players pursuant to the item-based revenue model. Under the item-based revenue model, the basic game play functions are free of charge and players are charged for purchases of in-game virtual items. Online game revenues are recognized over the estimated lives of the virtual items purchased or as the virtual items are consumed. If different assumptions were used in deriving the estimated lives of the virtual items, the timing of our recording of the revenues would be impacted. Game operations revenues are collected by Changyou's VIEs through the sale of Changyou's prepaid cards, which it sells in both virtual and physical forms to third-party distributors and players. Proceeds received from sales of prepaid cards are initially recorded as receipts in advance from customers and, upon activation or charge of the prepaid cards, are transferred from receipts in advance from customers to deferred revenues. As Changyou does not have control of, and generally does not know, the ultimate selling price of the prepaid cards sold by distributors, net proceeds from distributors form the basis of revenue recognition. Prepaid cards will expire two years after the date of card production if they have never been activated. The proceeds from the expired game cards are recognized as revenue upon expiration of cards. Once the prepaid cards are activated and credited to a player's personal game account, they will not expire as long as the personal game account remains active. Changyou is entitled to suspend and close a player's personal game account if it has been inactive for a period of 180 consecutive days. The unused balances in an inactive player's personal game account are recognized as revenues when the account is suspended and closed. Web game revenue Changyou began generating Web game revenue after its acquisition of a controlling interest in 7Road in May 2011. Through December 31, 2011, 7Road's revenues were derived entirely from revenue-sharing payments from third-party joint operators of its games and license fees from certain of these joint operators. Beginning in the year ended December 31, 2012, 7Road also derives revenues from direct operation of Wartune on its own Website for the game, which was launched in May 2012. The games developed by 7Road are operated primarily under the item-based revenue model, in which game players can access the games free of charge, but may purchase consumable virtual items, including those with a predetermined expiration time, or perpetual virtual items, such as certain costumes that stay bound to a game player throughout the life of the game. In certain of its joint operation arrangements, 7Road provides its games and related services to a third-party joint operator at no upfront fee. In these arrangements, 7Road is entitled to a single stream of revenue-sharing payments from the joint operator when game players convert the joint operator's virtual currency into 7Road's game coins or purchase its game coins directly through such operator's Websites or game platform. Certain of the joint operators pay 7Road license fees for the exclusive right to operate its games in specified geographic areas or upon achievement of certain performance milestones from the joint operators' operation of the games. Certain of the joint operators also pay 7Road license fees for the right to be among a selected few who will have the initial right ahead of other operators to jointly operate 7Road's games in China during a specified period after their launch. When 7Road's games are jointly operated through the Websites or platforms of third-party joint operators, the games may be hosted either on the third-party operators' servers or on servers that 7Road owns or leases from Internet data centers. In its arrangements with third-party joint operators, 7Road views the third-party joint operators as its customers and does not view 7Road as the primary obligor, as it does not have the primary responsibility for fulfillment and acceptability of the game services. For 7Road's direct operation of its Web game Wartune through its Website for the game, 7Road is obligated to provide on-going services to the game players, and such obligation is not deemed to be inconsequential and perfunctory after game players purchase its game coins directly through its Website for Wartune. Therefore, 7Road's revenues from direct operation of Wartune on its Website for the game are first recorded by 7Road as deferred revenues and subsequently recognized as revenue over the service period during which 7Road is obligated to provide services to the game players to enable them to consume their virtual items. -43--------------------------------------------------------------------------------- Table of Contents PRC tax authorities have determined that all of 7Road's game revenues from the joint operation of its games within China, which are generated through Shenzhen 7Road, are subject to 17% PRC VAT, and that Shenzhen 7Road, as a "Software Enterprise," is entitled to a 14% VAT refund immediately upon the filing of its VAT returns, with the result that 7Road's net effective PRC VAT rate is 3%. 7Road presents PRC VAT on a gross basis, by which VAT at the rate of 17% is included in revenues, and 7Road's net effective PRC VAT rate of 3% is included in cost of revenues, because Shenzhen 7Road's 17% VAT obligation and its entitlement to a 14% VAT refund are one integrated preferential VAT policy. Overseas licensing revenue Changyou enters into licensing arrangements with overseas licensees to operate its MMOGs in other countries or regions. These license agreements provide two revenue streams, consisting of an initial license fee and a monthly revenue-based royalty fee based on monthly revenue and sales from ancillary products of the games. The initial license fee is based on both a fixed amount and additional amounts receivable upon the games' achieving certain sales targets. Since Changyou is obligated to provide post-sales services such as technical support and provision of updates and when-and-if-available upgrades to the licensees during the license period, the initial license fee from the licensing arrangement is recognized as revenue ratably over the license period. The fixed amount of the initial license fee is recognized ratably over the remaining license period from the launch of the game and the additional amount is recognized ratably over the remaining license period from the date when such additional amount is certain. The monthly revenue-based royalty fee is recognized when relevant services are delivered, provided that collectability is reasonably assured. Wireless Revenues Our wireless revenues are generated from the provision of mobile-related services through different types of wireless products to mobile phone users. The wireless products mainly consist of SMS, IVR, mobile games, mobile video and RBT. In order to deliver our products to mobile phone users, we sign contracts with China Mobile Communications Corporation, China United Network Communication Group Company Limited, China Telecom Corporation and their subsidiaries and other small mobile network operators (collectively, the "China mobile network operators"). We obtain fees from the China mobile network operators, which charge users on a monthly or per message /download basis for wireless services we provide. After the receipt of service fees from China mobile network operators, we make payments to third party wireless service alliance and content providers based on revenue-sharing arrangements. Currently, a majority of our wireless revenues are recorded on a gross basis, as we have the primary responsibility for fulfillment and acceptability of the wireless services. Wireless revenues are recognized in the month in which the service is performed, provided that no significant obligations remain. For the amount of revenues to be recognized, we rely on billing confirmations issued by the China mobile network operators. If at the end of each reporting period, an operator has not yet issued such billing confirmations, we estimate the amount of collectable wireless service fees and recognize revenue. When we later receive billing confirmations, we record a true-up accounting adjustment. For the three months ended March 31, 2013, 87% of our estimated wireless revenues were confirmed by billing confirmations received from the China mobile network operators. Generally, (i) within 15 to 120 days after the end of each month, we receive billing confirmations from the operators and (ii) within 30 to 180 days after delivering billing confirmations, each operator remits the wireless service fees, net of its service fees, to us. Others Revenues Others revenues are primarily generated from our business of offering IVAS with respect to Web games developed by third-party developers under revenue-sharing arrangements with the developers, our offering cinema advertisement slots to be shown in theaters before the screening of movies, and our sub-licensing of licensed video content to third parties. Revenues from IVAS We offer Web games developed by third-party developers and generate revenues from the provision of IVAS, including promotion, access maintenance and payment services, to third-party developers. Under revenue-sharing agreements that we sign with third-party developers, we collect payments from the end users for items sold, keep a pre-agreed percentage of the proceeds and remit the balance to the third-party developers. Revenues from IVAS are recognized when our obligations under the agreements and all other revenue recognition criteria have been met. -44- -------------------------------------------------------------------------------- Table of Contents Revenues from cinema advertisements For cinema advertising revenues, a contract is signed with the advertiser to establish a fixed price and specify advertising services to be provided. Based on the contracts, we provide advertisement placements in advertising slots to be shown in theatres before the screening of movies. Revenues from cinema advertising are recognized when all the recognition criteria are met. Depending on the terms of a customer contract, fees for services performed can be recognized according to two principal methods, consisting of the proportional performance method and the straight-line method. Under the proportional performance method, fees are generally recognized based on a percentage of the advertising slots actually delivered where the fee is earned on a per-advertising slot placement basis. Under the straight-line method, fees are recognized on a straight-line basis over the contract period when the fee is not paid based on the number of advertising slots actually delivered. Revenues from sub-licensing of licensed video content For licensed video content purchased on an exclusive basis with payment in cash, we have rights to sub-license to other platforms. Revenues from sub-licensing of licensed video content are recognized when the content is available for immediate and unconditional delivery under an existing sub-licensing arrangement, the sub-license period has begun and the sub-licensing fee is fixed or determinable and collection of the sub-licensing fee is reasonably assured. Share-based Compensation Expense Sohu, Changyou, Sogou, Sohu Video and 7Road all have incentive plans for the granting of share-based awards, including common stock /ordinary shares, share options, restricted shares and restricted share units, to their executive officers, management and employees. Share-based compensation expense is recognized as costs and /or expenses in the consolidated statements of comprehensive income based on the fair value of the related share-based awards on their grant dates. Share-based compensation expense is charged to the shareholders' equity or noncontrolling interest section in the consolidated balance sheets. The assumptions used in share-based compensation expense recognition represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. If factors change or different assumptions are used, our share-based compensation expense could be materially different for any period. Moreover, the 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 us for accounting purposes. Share-based Compensation Expense related to Sohu, Changyou, and Sogou Share-based Awards For Sohu share-based awards, in determining the fair value of share options granted, the Black-Scholes valuation model is applied; in determining the fair value of restricted share units granted, the public market price of the underlying shares on the grant dates is applied. For Changyou share-based awards, in determining the fair value of ordinary shares, restricted shares and restricted share units granted in 2008, the income approach /discounted cash flow method with a discount for lack of marketability was applied, given that the shares underlying the awards were not publicly traded at the time of grant. In determining the fair value of restricted share units granted in 2009 before Changyou's initial public offering, the fair value of the underlying shares was determined based on Changyou's offering price for its initial public offering. In determining the fair value of restricted share units granted after Changyou's initial public offering, the public market price of the underlying shares on the grant dates is applied. For Sogou share-based awards, in determining the fair value of share options granted, the income approach /discounted cash flow method with a discount for lack of marketability was applied, given that the shares underlying the awards were not publicly traded at the time of grant. Share-based compensation expense for the ordinary shares granted is fully recognized in the quarter during which these ordinary shares are granted. For share options, restricted shares and restricted share units granted with respect to Sohu shares and with respect to Changyou shares, compensation expense is recognized on an accelerated basis over the requisite service period. For share options granted with respect to Sogou shares, compensation expense is recognized on a straight-line basis over the estimated period during which the service period requirement and performance target will be met. The number of share-based awards for which the service is not expected to be rendered over the requisite period is estimated, and the related compensation expense is not recorded for that number of awards. -45- -------------------------------------------------------------------------------- Table of Contents Sohu Video Share-based Awards On January 4, 2012, Sohu Video, the holding entity of Sohu's video division, adopted a 2011 Share Incentive Plan (the "Video 2011 Share Incentive Plan") which provides for the issuance of up to 25,000,000 ordinary shares of Sohu Video (amounting to 10% of the outstanding Sohu Video shares on a fully-diluted basis) to management and key employees of the video division and to Sohu management. As of March 31, 2013, grants of options for the purchase of 15,352,200 of ordinary shares of Sohu Video had been made and were effective under the Video 2011 Share Incentive Plan. However, as of March 31, 2013, the restructuring of Sohu's video division was still in process and certain significant factors remained uncertain. For purposes of ASC 718, no grant date is established until mutual understanding of the option awards' key terms and conditions between Sohu Video and the recipients can be reached, and such mutual understanding cannot be reached until the video division's restructuring plan has been substantially fixed, so that the enterprise value of Sohu Video and hence the fair value of the options is determinable and can be accounted for. As a result, on the basis that the broader terms and conditions of the option awards had neither been finalized nor mutually agreed with the recipients, no grant of options occurred for purposes of ASC 718 and hence no share-based compensation expense was recognized for the three months ended March 31, 2013. 7Road Share-based Awards On July 10, 2012, 7Road adopted a 2012 Share Incentive Plan (the "7Road 2012 Share Incentive Plan"), which initially provided for the issuance to selected directors, officers, employees, consultants and advisors of 7Road of up to 5,100,000 ordinary shares of 7Road (amounting to 5.1% of the then outstanding 7Road shares on a fully-diluted basis). On November 2, 2012, 7Road's Board of Directors and its shareholders approved an increase from 5,100,000 to 15,100,000 ordinary shares (amounting to 13.7% of the then outstanding 7Road shares on a fully-diluted basis) under the 7Road 2012 Share Incentive Plan. As of March 31, 2013, 2,546,250 restricted share units had been granted under the plan. Such restricted share units will not be vested until 7Road's completion of a firm commitment underwritten initial public offering (the "IPO") of its shares resulting in a listing on an internationally recognized exchange and the expiration of all underwriters' lockup periods applicable to the IPO. The completion of a firm commitment IPO is considered to be a performance condition of the awards. An IPO event is not considered to be probable until it is completed. Under ASC 718, compensation cost should be accrued if it is probable that the performance condition will be achieved and should not be accrued if it is not probable that the performance condition will be achieved. As a result, no compensation expense will be recognized related to these restricted share units until the completion of an IPO, and hence no share-based compensation expense was recognized for the quarter ended March 31, 2013. Taxation 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 our financial statements or tax returns. Deferred income taxes are determined based on the differences between the accounting basis and the tax basis of assets and liabilities and are measured using the currently enacted tax rates and laws. Deferred tax assets are reduced by a valuation allowance, if based on available evidence, it is considered that it is more likely than not that some portion of or all of the deferred tax assets will not be realized. In making such determination, we consider factors including future reversals of existing taxable temporary differences, future profitability, and tax planning strategies. 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. Our deferred tax assets relate to net operating losses and temporary differences between accounting basis and tax basis for our China-based subsidiaries and VIEs, which are subject to corporate income tax in the PRC under the PRC Corporate Income Tax Law (the "CIT Law"). PRC Withholding Tax on Dividends The CIT Law imposes a 10% withholding income tax for dividends distributed by foreign invested enterprises to their immediate holding companies outside mainland China. A lower withholding tax rate will be applied if there is a tax treaty between mainland China and the jurisdiction of the foreign holding company. A holding company in Hong Kong, for example, will be subject to a 5% withholding tax rate under the Arrangement Between the PRC and the Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital, (the "China-HK Tax Arrangement"), if such holding company is considered a non-PRC resident enterprise and holds at least 25% of the equity interests in the PRC foreign invested enterprise distributing the dividends, subject to approval of the PRC local tax authority. However, if the Hong Kong holding company is not considered to be the beneficial owner of such dividends under applicable PRC tax regulations, such dividend may remain subject to a withholding tax rate of 10%. -46- -------------------------------------------------------------------------------- Table of Contents Changyou's Board of Directors determined to cause one of Changyou's PRC subsidiaries to distribute all of its 2012 earnings and a portion of its 2013 earnings, respectively, to its overseas parent company, Changyou.com HK Limited ("Changyou HK"). Based on an assessment performed pursuant to requirements specified by PRC tax authorities, Changyou concluded that it was more likely than not that such distribution would be subject to 5% withholding tax. As of March 31, 2013, Changyou had accrued deferred tax liabilities in the amount of $13.6 million for withholding taxes associated with this distribution plan. Uncertain Tax Positions In order to assess uncertain tax positions, we apply a more likely than not threshold and a two-step approach for tax position measurement and financial statement recognition. For the two-step approach, the first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be realized upon settlement. Transition from PRC Business Tax to PRC Value Added Tax Effective September 1, 2012, the Pilot Program for transition from the imposition of Business Tax to the imposition of VAT for revenues from certain industries was expanded from Shanghai to eight other cities and provinces in China, including Beijing and Tianjin. Our brand advertising and search revenues are subject to this program. Business Tax had been imposed primarily on revenues from the provision of taxable services, assignments of intangible assets and transfers of real estate. Prior to the implementation of the pilot program, our Business Tax rate, which varies depending upon the nature of the revenues being taxed, generally ranged from 3% to 5%. VAT payable on goods sold or taxable labor services provided by a general VAT taxpayer for a taxable period is the net balance of the output VAT for the period after crediting the input VAT for the period. Before the implementation of the Pilot Program, we were mainly subject to a small amount of VAT for revenues of Changyou's subsidiary 7Road that are deemed for PRC tax purposes to be derived from the sale of software. VAT has been imposed on those 7Road revenues at a rate of 17%, with a 14% immediate tax refund, resulting in a net rate of 3%. With the implementation of the Pilot Program, in addition to the 7Road revenues, our brand advertising and search revenues are now subject to VAT at a rate of 6%. Under ASC 605-45, the presentation of taxes on either a gross basis (included in revenues and costs) or a net basis (excluded from revenues) is an accounting policy decision determined by management. As VAT imposed on brand adverting and search revenues and VAT imposed on 7Road's revenues from the sale of software are considered as substantially different in nature, we determined that it is reasonable to apply the guidance separately for these two types of VAT. The basis for this determination is that VAT payable on brand advertising and search revenues is the difference between the output VAT (at a rate of 6%) and available input VAT amount (at the rate applicable to the supplier), which is a component of our costs for providing the brand advertising and search services. On the other hand, VAT payable by 7Road is in effect at 3% of the applicable revenues from the sale of software, irrespective of the availability of any input VAT, under preferential VAT treatment provided to 7Road by the local tax bureau. In this regard, we believe the VAT payable by 7Road is more akin to a sales tax than typical VAT. As a result, we adopted the net presentation method for our brand advertising and search businesses both before and after the implementation of the Pilot Program, and for the revenues of 7Road deemed to be derived from the sale of software we adopted the gross presentation method before and after the implementation of the Pilot Program. U.S. Corporate Income Tax Sohu.com Inc. is a Delaware corporation that is subject to U.S. corporate income tax on its taxable income at a rate of 34% or 35%. Subject to certain limitations, the net operating losses ("NOLs") of a corporation taxable in the U.S. that are carried forward from prior years may be used to offset the corporation's taxable income. As of the end of the 2012 taxable year, Sohu.com Inc. had no further NOLs available for offsetting any U.S. taxable income. Accordingly, to the extent that Sohu.com Inc. has U.S. taxable income in 2013, we will begin to accrue U.S. corporate income tax in our consolidated statements of comprehensive income and make estimated tax payments as and when required by U.S. law. -47- -------------------------------------------------------------------------------- Table of Contents Net Income per Share Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted average number of common shares and, if dilutive, potential common shares outstanding during the period. Potential common shares comprise shares issuable upon the exercise or settlement of share-based awards. Potential common shares are accounted for in the computation of diluted earnings per share using the treasury stock method. The dilutive effect of share-based awards with performance requirements is not considered before the performance targets are actually met. The computation of diluted net income per share does not assume conversion, exercise, or contingent issuance of securities that would have an anti-dilutive effect (i.e., an increase in earnings per share amounts or a decrease in loss per share amounts) on net income per share. Additionally, for purposes of calculating the numerator of diluted net income per share, the net income attributable to Sohu is adjusted as follows: (1) Changyou's net income attributable to Sohu is determined using the percentage that the weighted average number of Changyou shares held by Sohu represents of the weighted average number of Changyou ordinary shares and shares issuable upon the exercise or settlement of share-based awards under the treasury stock method, instead of by the percentage held by Sohu of the total economic interest in Changyou, which is used for the calculation of basic net income per share. (2) Sogou's net income /(loss) attributable to Sohu is determined using the percentage that the weighted average number of Sogou shares held by Sohu represents of the weighted average number of Sogou ordinary shares and Series A Preferred Shares, shares issuable upon the conversion of convertible preferred shares under the if-converted method, and shares issuable upon the exercise or settlement of share-based awards under the treasury stock method, instead of by Sogou's net income /(loss) allocated to Sohu by virtue of the Sogou Series A Terms, the terms of the restructuring and Sohu's purchase of Sogou Series A Preferred Shares from Alibaba, which is used for the calculation of basic net income per share. Fair Value of Financial Instruments U.S. GAAP establishes a three-tier hierarchy to prioritize the inputs used in the valuation methodologies in measuring the fair value of financial instruments. This hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The three-tier fair value hierarchy is: Level 1-observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2-include other inputs that are directly or indirectly observable in the market place. Level 3-unobservable inputs which are supported by little or no market activity. Our financial instruments include cash equivalents, restricted time deposits, short-term investments, accounts receivable, investments in debt securities, prepaid and other current assets, prepaid non-current assets, accounts payable, short-term bank loans, accrued liabilities, receipts in advance and deferred revenue, other short-term liabilities, long-term accounts payable and long-term bank loans. Cash Equivalents Our cash equivalents mainly consist of time deposits placed with banks with an original maturity of three months or less. Restricted time deposits Changyou bridge loans from offshore banks secured by time deposits As of March 31, 2013 we had, through Changyou, bridge loans from offshore banks. These bridge loans are secured by RMB deposits in onshore branches of those banks. The bridge loans from the offshore branches of the lending banks are classified as short-term bank loans or long-term bank loans based on their repayment period. The rates of interest under the loan agreements with the lending banks were determined based on the prevailing interest rates in the market. The RMB onshore deposits securing the offshore loans are treated as restricted time deposits on our consolidated balance sheets. Restricted time deposits are valued based on the prevailing interest rates in the market. Collateral related to Sogou incentive shares trust arrangements In February 2013, we deposited $9 million in cash into a restricted time deposits account at a bank as collateral for credit facilities provided by the bank to certain Sogou employees. The facilities are intended to fund the employees' early exercise of Sogou share options and related PRC individual income tax. We are not subject to any additional potential payments other than the restricted time deposits amount, and believe that the fair value of our guarantee liability is immaterial. The restricted time deposits are valued based on the prevailing interest rates in the market. Short-term Investments For investments in financial instruments with a variable interest rate indexed to the performance of underlying assets, we elected the fair value method at the date of initial recognition and carried these investments subsequently at fair value. Changes in the fair value are reflected in the consolidated statements of comprehensive income. -48- -------------------------------------------------------------------------------- Table of Contents Accounts Receivable, Net The carrying value of accounts receivable is reduced by an allowance that reflects our best estimate of the amounts that will not be collected. We make estimations of the collectability of accounts receivable. Many factors are considered in estimating the general allowance, including reviewing delinquent accounts receivable, performing an aging analysis and a customer credit analysis, and analyzing historical bad debt records and current economic trends. Additional allowance for specific doubtful accounts might be made if the financial conditions of our customers or the China mobile network operators deteriorate or the China mobile network operators are unable to collect fees from their end customers, resulting in their inability to make payments due to us. Investments in Debt Securities We invest our excess cash in certain debt securities of high-quality corporate issuers. We elected the fair value option to account for our investments in debt securities at their initial recognition. Changes in the fair value are reflected in the consolidated statements of comprehensive income as other income /(expense). The fair value election was made to mitigate accounting mismatches and to achieve operational simplifications. Equity Investments Investments in entities over which we do not have significant influence are recorded as equity investments and are accounted for by the cost method. Investments in entities over which we have significant influence but do not control are also recorded as equity investments and are accounted for by the equity method. Under the equity method, our share of the post-acquisition profits or losses of the equity investment is recognized in our consolidated statements of comprehensive income; and our share of post-acquisition movements in equity investments is recognized in equity in our consolidated balance sheets. Unrealized gains on transactions between us and our equity investees are eliminated to the extent of the interest in the equity investments. Unrealized losses are also eliminated unless the transaction provides evidence of an impairment of the asset transferred. When our share of losses in an equity investment equals or exceeds our interest in the equity investment, we do not recognize further losses, unless we have incurred obligations or made payments on behalf of the equity investee. Long-Lived Assets Long-lived assets include fixed assets, intangible assets and prepaid non-current assets. Fixed Assets Fixed assets mainly comprise office building, leasehold improvements, vehicles, office furniture, and computer equipment and hardware. Fixed assets are recorded at cost less accumulated depreciation with no residual value. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Expenditure for maintenance and repairs is expensed as incurred. The gain or loss on the disposal of fixed assets is the difference between the net sales proceeds and the lower of the carrying value or fair value less cost to sell the relevant assets and is recognized in operating expenses in the consolidated statements of comprehensive income. Intangible Assets Intangible assets mainly comprise video content and license, customer lists, developed technologies, computer software purchased from unrelated third parties, domain names and trademarks, and operating rights for licensed games. Intangible assets are recorded at cost less accumulated amortization with no residual value. Amortization of intangible assets other than licensed video content is computed using the straight-line method over their estimated useful lives. We amortize licensed video content over the shorter of the term of the estimated period over which the benefits of the license agreement will be enjoyed based on the trend of accumulation of viewership or the applicable license period. Beginning in the third quarter of 2011, licensed video content is amortized on an accelerated basis based on the viewership accumulation trend over the shorter of the term of the estimated period over which the benefits of the license contract will be enjoyed or the applicable license period. For exclusively licensed video content which we sub-licensed to similar platforms in return for payment in cash, we allocate a portion of the video content cost from cost of brand advertising revenues to sub-licensing cost. The allocation is based on the revenues to be generated through sub-licensing. We amortize sub-licensing cost using the individual-film-forecast-computation method, which amortizes such costs in the same ratio that actual sub-licensing revenue bears as of the current period end to the total of the actual revenue earned and the estimated remaining unrecognized ultimate revenue. -49--------------------------------------------------------------------------------- Table of Contents Prepaid non-current Assets Prepaid non-current assets primarily include prepayments for the office buildings to be built as our and Changyou's headquarters before they are recognized as fixed assets, prepayments for the technological infrastructure and fitting-out of our office building before they are recognized as fixed assets, and prepaid PRC income tax arising from the sale of certain assets associated with the 17173 Business by us to Changyou. Since the sale of the 17173 Business was between entities that are included in our consolidated financial statements, it was considered an "intra-entity transaction" and, under ASC 810-10, income taxes paid should be deferred. Accordingly, we recorded income tax related to the sale of the 17173 Business as prepaid PRC income tax. The prepaid PRC income tax will be amortized over the period of the weighted average remaining life of the 17173 Business-related assets sold to Changyou. Impairment of Long-lived Assets In accordance with ASC 360-10-35, we review the carrying values of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. Based on the existence of one or more indicators of impairment, we measure any impairment of long-lived assets using the projected discounted cash flow method at the asset group level. The estimation of future cash flows requires significant management judgment based on our historical results and anticipated results and is subject to many factors. The discount rate that is commensurate with the risk inherent in our business model is determined by our management. An impairment loss would be recorded if we determined that the carrying value of long-lived assets may not be recoverable. The impairment to be recognized is measured by the amount by which the carrying values of the assets exceed the fair value of the assets. Goodwill Goodwill represents the excess of the purchase price over the fair value of the identifiable assets and liabilities acquired as a result of our acquisitions of interests in our subsidiaries and consolidated VIEs. We test goodwill for impairment at the reporting unit level on an annual basis as of October 1, and between annual tests when an event occurs or circumstances change that could indicate that the asset might be impaired. Commencing in September 2011, we adopted the Financial Accounting Standards Board ("FASB") revised guidance on "Testing of Goodwill for Impairment." Under this guidance, we have the option to choose whether we will apply the qualitative assessment first and then the quantitative assessment, if necessary, or to apply the quantitative assessment directly. For reporting units applying a qualitative assessment first, we start the goodwill impairment test by assessing qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If we determine that it is more-likely-than-not the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is mandatory. Otherwise, no further testing is required. The quantitative impairment test consists of a comparison of the fair value of goodwill with its carrying value. For reporting units directly applying the quantitative assessment, we perform the goodwill impairment test by quantitatively comparing the fair values of those reporting units to their carrying amounts. Application of a goodwill impairment test requires significant management 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. The judgment in estimating the fair value of reporting units includes 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. Mezzanine Equity On May 11, 2011, Changyou, through its VIE Gamease, acquired 68.258% of the equity interests of Shenzhen 7Road and began to consolidate Shenzhen 7Road's financial statements on June 1, 2011. Our Mezzanine Equity consists of noncontrolling interest in 7Road and a put option pursuant to which the noncontrolling shareholders will have the right to put their equity interests in 7Road to Changyou at a pre-determined price if 7Road achieves specified performance milestones before the expiration of the put option and 7Road does not complete an initial public offering on NASDAQ, the NYSE or the HKEX. The put option will expire in 2014. Since the occurrence of the sale is not solely within the control of Changyou, we classify the noncontrolling interest as mezzanine equity instead of permanent equity in our and Changyou's consolidated financial statements. Under ASC 480-10, we calculate, on an accumulative basis from the acquisition date, (i) the amount of accretion that would increase the balance of noncontrolling interest to its estimated redemption value over the period from the date of the Shenzhen 7Road acquisition to the earliest redemption date of the noncontrolling interest in 7Road and (ii) the amount of net profit attributable to noncontrolling shareholders of 7Road based on their ownership percentage. The carrying value of the noncontrolling interest as mezzanine equity will be adjusted by an accumulative amount equal to the higher of (i) and (ii). -50- -------------------------------------------------------------------------------- Table of Contents On June 21, 2012, 7Road's then Chief Executive Officer surrendered to 7Road, without consideration, ordinary shares of 7Road representing 5.1% of the then outstanding ordinary shares of 7Road. As a result, the noncontrolling interest decreased to 28.074% of 7Road and Changyou's interest in 7Road increased to 71.926%. Under ASC 480-10, changes in a parent's ownership interest while the parent retains control of its subsidiary are accounted for as equity transactions, and do not impact net income or comprehensive income in the consolidated financial statements. The variance of $6.8 million caused by 7Road's Chief Executive Officer's surrender of shares was recorded as credit to additional paid-in capital. For the three months ended March 31, 2013, an accretion charge of $10.7 million, compared to $1.1 million for the three months ended March 31, 2012, was recorded as net income attributable to the mezzanine classified noncontrolling interest shareholders in the statements of comprehensive income. 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 our consolidated balance sheets, includes a cumulative foreign currency translation adjustment. Functional Currency and Foreign Currency Translation Functional Currency 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 the entity primarily generates and expends cash. Management's judgment is essential to determine the functional currency by assessing various indicators, such as cash flows, sales price and market, expenses, financing and inter-company transactions and arrangements. The functional currency of Sohu.com Inc. is the U.S. dollar. The functional currency of our subsidiaries in the U.S., the Cayman Islands, the British Virgin Islands and Hong Kong is the U.S. dollar. The functional currencies of our subsidiaries and VIEs in the PRC, the United Kingdom, Malaysia and Korea are the national currencies of those counties. Foreign Currency Translation Assets and liabilities of our China-based subsidiaries and VIEs, the United Kingdom, Malaysia and Korea are translated into U.S. dollars, our reporting currency, at the exchange rate in effect at the balance sheets date and revenues and expenses are translated at the average exchange rates in effect during the reporting period. Foreign currency translation adjustments are not included in determining net income for the period but are accumulated in a separate component of equity in our consolidated balance sheets. Foreign currency transactions denominated in currencies other than the functional currency are translated into the functional currency using the exchange rates prevailing at the dates of the transactions. Monetary assets and liabilities denominated in foreign currencies at the balance sheet date are re-measured at the applicable rates of exchange in effect at that date. Gains and losses resulting from foreign currency re-measurement are included in the consolidated statements of comprehensive income. RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2013 AND 2012 Reclassification of revenues and costs related to Changyou IVAS Commencing January 1, 2013, in order to provide a better foundation for understanding Changyou's performance, both revenues and costs generated from the operation of third-party Web games by the 17173 business were reclassified from the online game business to IVAS in the others business. To conform to current period presentations, the relevant amounts for prior periods have been reclassified accordingly. Such reclassifications amounted to $1.5 million for revenues and $0.6 million for costs for the three months ended March 31, 2012. -51- -------------------------------------------------------------------------------- Table of Contents Revenues The following table presents our revenues by revenue source and by proportion for the periods indicated (in thousands, except percentages): Three Months Ended March 31, 2013 2012 2013 VS 2012 Revenues: Online advertising: Brand advertising $ 80,237 26 % $ 60,968 27 % $ 19,269 Search and others 36,052 12 % 21,637 10 % 14,415 Subtotal of online advertising Revenues 116,289 38 % 82,605 37 % 33,684 Online game 167,421 55 % 125,968 55 % 41,453 Wireless 13,773 4 % 13,351 6 % 422 Others 10,113 3 % 4,680 2 % 5,433 Total revenues $ 307,596 100 % $ 226,604 100 % $ 80,992 Total revenues were $307.6 million for the three months ended March 31, 2013, compared to $226.6 million for the three months ended March 31, 2012. The year-on-year increase in total revenues for the first quarter of 2013 was $81.0 million. The increase was mainly attributable to increases in online game revenues and online advertising revenues. Online Advertising Revenues Online advertising revenues were $116.3 million for the three months ended March 31, 2013, compared to $82.6 million for the three months ended March 31, 2012. The year-on-year increase in online advertising revenues for the first quarter of 2013 was $33.7 million. The increase was mainly attributable to increases in brand advertising revenues and search and others revenues. Brand Advertising Revenues Brand advertising revenues were $80.2 million for the three months ended March 31, 2013, compared to $61.0 million for the three months ended March 31, 2012. The year-on-year increase in brand advertising revenues for the first quarter of 2013 was $19.2 million. The increase was mainly attributable to an increase in revenues from the sectors of real estate and fast-moving consumer goods industries. We expect brand advertising revenues to increase in the second quarter of 2013, compared to the first quarter of 2013. Search and Others Revenues Search and others revenues were $36.1 million for the three months ended March 31, 2013, compared to $21.6 million for the three months ended March 31, 2012. The year-on-year increase in search and others revenues for the first quarter of 2013 was $14.5 million. The increase was mainly contributed by pay-for-click services, as well as online marketing services on the Sogou Web Directory, both as a result of increased traffic and improved monetization of traffic. We expect search and others revenues to increase in the second quarter of 2013, compared to the first quarter of 2013. Online Game Revenues Online game revenues were $167.4 million for the three months ended March 31, 2013, compared to $126.0 million for the three months ended March 31, 2012. The year-on-year increase in online game revenues for the first quarter of 2013 was $41.4 million. The increase was mainly due to the growth momentum of TLBB and Wartune in the first quarter of 2013. For the three months ended March 31, 2013, average revenue per active paying account of our games in China increased by 77% to RMB399, from RMB225 for the three months ended March 31, 2012. We expect online game revenues to be flat in the second quarter of 2013, compared to the first quarter of 2013. Wireless Revenues Wireless revenues were $13.8 million for the three months ended March 31, 2013, compared to $13.4 million for the three months ended March 31, 2012. The year-on-year increase in wireless revenues for the first quarter of 2013 was $0.4 million. We expect wireless revenues to increase in the second quarter of 2013 compared to the first quarter of 2013. -52--------------------------------------------------------------------------------- Table of Contents Others Revenues Revenues for other services were $10.1 million for the three months ended March 31, 2013, compared to $4.7 million for the three months ended March 31, 2012. The year-on-year increase in others revenues for the first quarter of 2013 was $5.4 million. The increase was mainly due to increased revenues from IVAS and sub-licensing of licensed video content. Costs and Expenses Cost of Revenues The following table presents our cost of revenues by source and by proportion for the periods indicated (in thousands, except percentages): Three Months Ended March 31, 2013 2012 2013 VS 2012 Cost of revenues: Online advertising: Brand advertising $ 44,878 43 % $ 36,892 46 % $ 7,986 Search and others 20,792 20 % 13,128 17 % 7,664 Subtotal of cost of online advertising revenues 65,670 63 % 50,020 63 % 15,650 Online game 22,650 22 % 15,831 20 % 6,819 Wireless 9,271 9 % 8,853 11 % 418 Others 5,938 6 % 4,818 6 % 1,120 Total cost of revenues $ 103,529 100 % $ 79,522 100 % $ 24,007 Total cost of revenues was $103.5 million for the three months ended March 31, 2013, compared to $79.5 million for the three months ended March 31, 2012. The increase in total cost of revenues for the first quarter of 2013 was $24.0 million. The increase was mainly attributable to increases in cost of online advertising revenues and cost of online game revenues. Cost of Online Advertising Revenues Cost of online advertising revenues was $65.7 million for the three months ended March 31, 2013, compared to $50.0 million for the three months ended March 31, 2012. The year-on-year increase in cost of online advertising revenues for the first quarter of 2013 was $15.7 million. The increase was mainly attributable to increases in cost of brand advertising and search and others revenues. Cost of Brand Advertising Revenues Cost of brand advertising revenues mainly consists of amortization of content and license costs, bandwidth leasing costs, salary and benefits expenses, and depreciation expenses. Cost of brand advertising revenues was $44.9 million for the three months ended March 31, 2013, compared to $36.9 million for the three months ended March 31, 2012. The year-on-year increase in cost of brand advertising revenues for the first quarter of 2013 was $8.0 million. The increase mainly consisted of a $3.5 million increase in salary and benefits expenses, a $3.2 million increase in amortization of content and license costs, a $0.7 million increase in depreciation expenses, and a $0.5 million increase in bandwidth leasing costs. Our brand advertising gross margin was 44% and 39%, respectively, for the three months ended March 31, 2013 and 2012. The increase in our brand advertising gross margin was mainly due to the growth in brand advertising revenues having been faster than the increase in cost of brand advertising revenues. Cost of Search and Others Revenues Cost of search and others revenues mainly consists of traffic acquisition costs, bandwidth leasing costs, depreciation expenses, as well as salary and benefits expenses. Cost of search and others revenues was $20.8 million for the three months ended March 31, 2013, compared to $13.1 million for the three months ended March 31, 2012. The year-on-year increase in cost of search and others revenues for the first quarter of 2013 was $7.7 million. The increase mainly consisted of a $5.0 million increase in traffic acquisition costs, a $1.4 million increase in depreciation expenses, a $0.9 million increase in bandwidth leasing costs along with increased traffic volume, and a $0.4 million increase in salary and benefits expenses. -53- -------------------------------------------------------------------------------- Table of Contents Our search and others gross margin was 42% and 39%, respectively, for the three months ended March 31, 2013 and 2012. The increase in our search and others gross margin was mainly due to higher revenues from the improved monetization of traffic and lower percentage of traffic acquisition costs in cost of search and others revenues. Cost of Online Game Revenues Cost of online game revenues mainly consists of salary and benefits expenses, bandwidth leasing charges, depreciation expenses, revenue-based royalty payments to game developers, and Business Tax and VAT arising from transactions between Changyou's subsidiaries and its VIEs. Cost of online game revenues was $22.7 million for the three months ended March 31, 2013, compared to $15.8 million for the three months ended March 31, 2012. The year-on-year increase in cost of online game revenues for the first quarter of 2013 was $6.9 million. The increase mainly consisted of a $3.3 million increase in salary and benefits expenses, a $1.4 million increase in Business Tax and VAT, and a $1.3 million increase in bandwidth leasing costs. Our online game gross margin was 86% and 87%, respectively, for the three months ended March 31, 2013 and 2012. Cost of Wireless Revenues Cost of wireless revenues mainly consists of revenue-sharing payments (which include payments to third party wireless service alliances and content providers), collection charges and transmission fees paid to China mobile network operators, bandwidth leasing costs and depreciation expenses. Cost of wireless revenues was $9.3 million for the three months ended March 31, 2013, compared to $8.9 million for the three months ended March 31, 2012. The year-on-year increase in cost of wireless revenues for the first quarter of 2013 was $0.4 million. The collection charges and transmission fees varied between China mobile network operators. The collection charges and transmission fees mainly include (i) a gateway fee of $0.008 to $0.032 per message in both the first quarter of 2013 and 2012, depending on the volume of the monthly total wireless messages, and (ii) a collection fee of 15% to 87% of total fees collected by China mobile network operators from mobile phone users (with the residual paid to us) in both the first quarter of 2013 and 2012. Our wireless gross margin was 33% and 34%, respectively, for the three months ended March 31, 2013 and 2012. Cost of Revenues for Other Services Cost of revenues for other services mainly consists of payments to theatres and film production companies for pre-film screening advertisement slots, charges for impairment of intangible assets and amortization of sub-licensing cost. Cost of revenues for other services was $5.9 million for the three months ended March 31, 2013, compared to $4.8 million for three months ended March 31, 2012. The year-on-year increase in cost of revenues for the first quarter of 2013 was $1.1 million. The increases were mainly due to amortization of sub-licensing cost and payments for the cinema advertisement business. Operating Expenses The following table presents our operating expenses by nature and by proportion for the periods indicated (in thousands, except percentages): Three Months Ended March 31, 2013 2012 2013 VS 2012 Operating expenses: Product development $ 51,819 39 % $ 38,593 40 % $ 13,226 Sales and marketing 58,723 44 % 38,654 41 % 20,069 General and administrative 22,589 17 % 17,794 19 % 4,795 Total operating expenses $ 133,131 100 % $ 95,041 100 % $ 38,090 Total operating expenses were $133.1 million for the three months ended March 31, 2013, compared to $95.0 million for the three months ended March 31, 2012. The year-on-year increase in total operating expenses for the first quarter of 2013 was $38.1 million. The increases were mainly due to increases in sales and marketing expenses and product development expenses. -54--------------------------------------------------------------------------------- Table of Contents Product Development Expenses Product development expenses mainly consist of personnel-related expenses incurred for enhancement and maintenance of our Websites, and costs associated with new product development and maintenance, as well as enhancement of existing products and services, which mainly include the development costs of online games prior to the establishment of technological feasibility and maintenance costs after the online games are available for marketing. Product development expenses were $51.8 million for the three months ended March 31, 2013, compared to $38.6 million for the three months ended March 31, 2012. The year-on-year increase in product development expenses for the first quarter of 2013 was $13.2 million. The increase mainly consisted of a $13.6 million increase in salary and benefits expenses, offset by a 0.8 million decrease in share-based compensation expenses. Sales and Marketing Expenses Sales and marketing expenses mainly consist of advertising and promotional expenditures, salary and benefits expenses, travel expenses, and facility expenses. Sales and marketing expenses were $58.7 million for the three months ended March 31, 2013, compared to $38.7 million for the three months ended March 31, 2012. The year-on-year increase in sales and marketing expenses for the first quarter of 2013 was $20.0 million. The increase mainly consisted of a $10.2 million increase in advertising and promotional expenditures as a result of increased marketing and promotion activities, an $8.4 million increase in salary and benefits expenses, and a $1.2 million increase in travel expenses. General and Administrative Expenses General and administrative expenses mainly consist of salary and benefits expenses, professional service fees, travel expenses, and facility expenses. General and administrative expenses were $22.6 million for the three months ended March 31, 2013, compared to $17.8 million for the three months ended March 31, 2012. The year-on-year increase in general and administrative expenses for the first quarter of 2013 was $4.8 million. The increase mainly consisted of a $3.6 million increase in professional service fees, a $2.7 million increase in salary and benefits expenses, and a $1.2 million increase in travel expenses, offset by a $2.9 million decrease in bad debt expenses. Share-based Compensation Expense Sohu, Changyou, Sogou, Sohu Video and 7Road all have incentive plans for the granting of share-based awards, including common stock /ordinary shares, share options, restricted shares and restricted share units, to their employees and directors. Share-based compensation expense was recognized in costs and /or expenses for the three months ended March 31, 2013 and March 31, 2012, respectively, as follows (in thousands): Three Months Ended March 31, Share-based compensation expense 2013 2012 Cost of revenues $ 70 $ 270 Product development expenses 350 1,172 Sales and marketing expenses 172 534 General and administrative expenses 494 954 $ 1,086 $ 2,930 Share-based compensation expense recognized for share awards of Sohu, Changyou, Sogou, Sohu Video and 7Road, was as follows (in thousands): Three Months Ended March 31, Share-based compensation expense 2013 2012 For Sohu share-based awards $ 861 $ 1,703 For Changyou share-based awards 209 1,206 For Sogou share-based awards 16 21 For Sohu Video share-based awards 0 0 For 7Road share-based awards 0 - $ 1,086 $ 2,930 -55- -------------------------------------------------------------------------------- Table of Contents For Sohu share options, as of March 31, 2013 there was no unrecognized compensation expense because the requisite service periods for the remaining share options had ended by the end of 2009. For Sohu restricted share units, as of March 31, 2013, there was $2.4 million of unrecognized compensation expense. For Changyou share-based awards, as of March 31, 2013, there was $1.7 million of unrecognized compensation expense. For Sogou share-based awards, as of March 31, 2013, there was $0.02 million of unrecognized compensation expense. No share-based compensation expense was recognized for the three months ended March 31, 2013 with respect to outstanding Sohu Video share options, because under U.S. GAAP no grant of options is deemed to have occurred as of that date as key terms of the options had not been agreed to. No share-based compensation expense was recognized for the three months ended March 31, 2013 with respect to outstanding 7Road restricted share units, because completion of an initial public offering by 7Road is a condition of vesting of those restricted share units, an initial public offering is not considered probable until it has occurred and under U.S. GAAP, no share-based compensation expense should be accrued until the occurrence of a performance condition is probable. Operating Profit As a result of the foregoing, our operating profit was $70.9 million for the three months ended March 31, 2013, compared to $52.0 million for the three months ended March 31, 2012. Other Income Other income was $2.5 million for the three months ended March 31, 2013, compared to $1.6 million for the three months ended March 31, 2012. Interest Income Interest income was $6.7 million for the three months ended March 31, 2013, compared to $6.5 million for the three months ended March 31, 2012. Income Tax Expense Income tax expense was $20.0 million for the three months ended March 31, 2013, compared to $18.7 million for the three months ended March 31, 2012. The year-on-year increase in income tax expense in the first quarter of 2013 was mainly due to an increase in U.S. corporate income tax expense of Sohu.com Inc. and an increase in PRC corporate income tax expense of the Sohu Group's China-based operations, with a decrease in the utilization of excess tax benefits from share-based compensation arrangements, which was nil in the first quarter of 2013. Net Income Net income was $58.2 million for the three months ended March 31, 2013, compared to $40.8 million for the three months ended March 31, 2012. Net Income Attributable to Noncontrolling Interest Net income attributable to noncontrolling interest was $23.1 million for the three months ended March 31, 2013, compared to $16.6 million for the three months ended March 31, 2012. The year-on-year increase in net income attributable to noncontrolling interest was mainly due to increased net income of Changyou. We expect the noncontrolling interest recognized for Changyou to decrease in the second quarter of 2013, compared to the first quarter of 2013, due to a decrease in Changyou's net income expected to result from increased salary and benefits expenses and more marketing and promotions. We expect the noncontrolling interest recognized for Sogou to remain at a low level. -56- -------------------------------------------------------------------------------- Table of Contents Net Income attributable to Sohu.com Inc. As a result of the foregoing, we had net income attributable to Sohu of $24.4 million for the three months ended March 31, 2013, compared to $23.1 million for the three months ended March 31, 2012. LIQUIDITY AND CAPITAL RESOURCES Resources Analysis Our principal sources of liquidity are cash and cash equivalents, short-term investments, investments in debt securities, as well as the cash flows generated from our operations. Cash equivalents primarily comprise time deposits. As of March 31, 2013, we had cash and cash equivalents, short-term investments and investments in debt securities of approximately $951.7 million. In addition, as of March 31, 2013 we had, through Changyou, bridge loans from offshore banks in the principal amount of $270 million. These bridge loans are secured by RMB deposits in onshore branches of those banks in the total amount of $278 million. As of March 31, 2012, we had cash and cash equivalents, short-term investments and investment in debt securities of approximately $871.2 million. In November 2009, we entered into an agreement to purchase a Beijing office building to serve as our headquarters. Of the purchase price of approximately $128 million, $125 million had been paid as of March 31, 2013. In December 2011, we also entered into an agreement for technological infrastructure and fitting-out work for the office building for a contractual amount of approximately $28 million, of which $23 million had been paid as of March 31, 2013. In the first quarter of 2013, the contractor agreed to reduce the contractual amount for the technological infrastructure and fitting-out work by $3 million, leaving a remaining balance of $2 million. These $125 million and $23 million payments have been recognized as prepaid non-current assets in our consolidated balance sheets. The majority of the remaining $5 million for the office building and the technological infrastructure and fitting-out work will be settled after construction of the office building has been completed, title has been delivered to us and the office building has passed a quality assurance period. The office building has been put to use in May 2013. In August 2010, Changyou entered into an agreement to purchase a Beijing office building to serve as its headquarters. The purchase price for the office building is approximately $161 million. As of March 31, 2013, $142 million had been paid and recognized as fixed assets. In accordance with the terms of the agreement, the remaining $19 million will be settled in the second quarter of 2013. As of March 31, 2013, the Sohu Group also had commitments for video content purchases in the amount of $43 million, commitments for bandwidth purchases in the amount of $42 million, commitments for operating leases in the amount of $29 million and commitments for other content and service purchases in the amount of $13 million. We believe our current liquidity and capital resources are sufficient to meet anticipated working capital needs (net cash used in operating activities), commitments and capital expenditures over the next twelve months. We may, however, require additional cash resources due to changes in business conditions and other future developments, or changes in general economic conditions. Cash Generating Ability We believe we will continue to generate strong cash flow from online game business, which, along with our available cash, will provide sufficient liquidity and financial flexibility. Our cash flows were summarized below (in thousands): Three Months Ended March 31, 2013 2012 Net cash provided by operating activities $ 46,768 $ 73,292 Net cash used in investing activities (103,380 ) (35,181 ) Net cash provided by /(used in) financing activities 17,185 (10,755 ) Effect of exchange rate change on cash and cash equivalents 4,222 1,481 Net (decrease)/ increase in cash and cash equivalents (35,205 ) 28,837 Cash and cash equivalents at beginning of period 833,535 732,607 Cash and cash equivalents at end of period $ 798,330 $ 761,444 -57- -------------------------------------------------------------------------------- Table of Contents Net Cash Provided by Operating Activities For the three months ended March 31, 2013, $46.8 million net cash provided by operating activities was primarily attributable to our net income of $58.2 million, adjusted by non-cash items of depreciation and amortization of $27.2 million, share-based compensation expense of $1.1 million, and impairment of other intangible assets of $0.4 million, offset by a decrease in cash from working capital items of $38.2 million, income from investments in debt securities of $1.4 million, and other miscellaneous non-cash expenses of $0.5 million. For the three months ended March 31, 2012, $73.3 million net cash provided by operating activities was primarily attributable to our net income of $40.8 million, adjusted by non-cash items of share-based compensation expense of $2.9 million, depreciation and amortization of $26.1 million, impairment of intangible assets of $0.6 million, provision for allowance for doubtful accounts of $3.0 million, and an increase in cash from working capital items of $2.3 million, offset by a decrease in cash of $1.4 million income from investments in debt securities and $1.0 million from excess tax benefits. In accordance with U.S. GAAP, the above excess tax benefits were presented as a reduction in cash flows from operating activities and a cash inflow from financing activities. Realizing these benefits reduces the amount of taxes payable and does not otherwise affect cash flows. Net Cash Used in Investing Activities For the three months ended March 31, 2013, $103.4 million net cash used in investing activities was primarily attributable to $47.0 million used to acquire fixed assets and intangible assets (including a $2.3 million payment for the office building acquired by Sohu and a $16.0 million payment for the office building acquired by Changyou), $30.8 million in restricted time deposits used as collateral for Changyou bridge loans from offshore banks, $9.0 million in restricted time deposits used as collateral for credit facilities provided by banks to certain Sogou employees, and $18.0 million used for short-term investments, offset by income from investments in debt securities of $1.4 million described above under the heading "Net Cash Provided by Operating Activities." For the three months ended March 31, 2012, $35.2 million net cash used in investing activities was primarily attributable to $23.5 million used in acquiring fixed assets and intangible assets, and $11.7 million used for the purchase of short-term investments. Net Cash Provided by /(Used in) Financing Activities For the three months ended March 31, 2013, $17.2 million net cash provided by financing activities was primarily attributable to $30.0 million of Changyou bridge loans from offshore banks, $5.2 million in proceeds received from early exercise of share-based awards in subsidiary, $1.3 million from the exercise of share-based awards in a subsidiary, and $0.4 million from the issuance of common stock upon the exercise of share options granted under our stock incentive plan, offset by $19.7 million used for contingent consideration paid by Changyou to 7Road's noncontrolling shareholders. For the three months ended March 31, 2012, $10.8 million net cash used in financing activities was primarily attributable to $12.6 million used for the repurchase of our common stock and $0.2 million from other cash payments relating to financing activities, offset by a $1.0 million from the exercise of share-based awards in subsidiary, and $1.0 million excess tax benefits mentioned above under the heading "Net Cash Provided by Operating Activities." Restrictions and Limitations on Cash Available to Sohu.com Inc. To fund any cash requirements it may have, Sohu.com Inc may need to rely on dividends and other distributions on equity paid by our wholly-owned subsidiary Sohu.com Limited or our majority-owned subsidiary Changyou.com Limited. Since substantially all of our operations are conducted through our indirect wholly-owned and majority-owned China-based subsidiaries and VIEs, Sohu.com Limited and Changyou.com Limited may need to rely on dividends, loans or advances made by our PRC subsidiaries in order to make dividends and other distributions to us. The ability of Sohu.com Limited and Changyou.com Limited to receive dividends and distributions from our China-based subsidiaries and VIEs, and the amount of cash available for distribution to, and use by, Sohu.com Inc., are subject to certain restrictions and limitations related to PRC law, our VIE structure and U.S. corporate income tax. We do not expect any of such restrictions or taxes to have a material impact on our ability to meet our cash obligations. -58--------------------------------------------------------------------------------- Table of Contents PRC profit appropriation, withholding tax on dividends and regulation of foreign currency exchange Regulations in the PRC currently permit payment of dividends of a PRC company only out of accumulated profits as determined in accordance with accounting standards and regulations in China. Our China-based subsidiaries, which are wholly foreign-owned enterprises ("WFOEs") under PRC law, are also required to set aside each year to their general reserves at least 10% of their after-tax profit based on PRC accounting standards, until the cumulative amount reaches 50% of their paid-in capital. These reserves may not be distributed as cash dividends, or as loans or advances. Our WFOEs may also allocate a portion of their after-tax profits, at the discretion of their Boards of Directors, to their staff welfare and bonus funds. Any amounts so allocated may not be distributed to Sohu.com Limited and /or Changyou.com Limited and, accordingly, would not be available for distribution to Sohu.com Inc. The PRC CIT Law generally imposes a 10% withholding tax on dividends distributed by WFOEs to their immediate holding companies outside mainland China, provided that a lower rate may apply under tax treaties between mainland China and other jurisdictions. For example, withholding tax for dividends to a holding company in Hong Kong may, under certain circumstances, be 5% rather than 10%. As of March 31, 2013, we had accrued deferred tax liabilities in the amount of $13.6 million for withholding taxes associated with dividends paid by Changyou's mainland China-based WFOEs to Changyou's Hong Kong subsidiary. Under regulations of the PRC State Administration of Foreign Exchange ("SAFE"), the RMB is not convertible into foreign currencies for capital account items, such as loans, repatriation of investments and investments outside of mainland China, unless prior approval of the SAFE is obtained and prior registration with the SAFE is made. PRC restrictions related to our VIE structure While generally our VIEs generate revenues and cash, almost all of our VIEs, with the exception of those related to Changyou's online game business, incur deficits as a result of significant costs involved in their operations, and had negative operating cash flow for the three months ended March 31, 2013. Substantially all of Changyou's operations are conducted through Changyou's VIEs, which generate all of Changyou's online game revenues. Although Changyou's subsidiaries received a majority of the VIEs' profits pursuant to contractual agreements between the VIEs and Changyou's PRC subsidiaries providing for payments to the subsidiaries in return for services provided to the VIEs by the PRC subsidiaries, significant cash balances remained in Changyou's VIEs as of March 31, 2013. As Changyou's VIEs are not owned by Changyou's PRC subsidiaries, the VIEs are not able to make dividend payments to the subsidiaries. Therefore, in order for Sohu.com Inc. and/or our subsidiaries outside of mainland China to receive any dividends, loans or advances from Changyou's PRC subsidiaries, we will need to rely on these contractual payments made by Changyou's VIEs to Changyou's PRC subsidiaries. Depending on the nature of services provided by Changyou's PRC subsidiaries to their corresponding VIEs, certain of these payments will subject to PRC taxes, including Business Tax and VAT, which will effectively reduce the amount that the PRC subsidiary receives from its corresponding VIE. In addition, the PRC government could impose restrictions on such payments or change the tax rates applicable to such payments. U.S. corporate income tax Sohu.com Inc. is a Delaware corporation and is subject to corporate income tax in the United States. Although in the past Sohu.com Inc. has been able to use NOLs to offset a portion of its U.S. taxable income, at the end of its 2012 taxable year it had no further NOLs available for offsetting any U.S. taxable income. The majority of our subsidiaries and VIEs are based in China and are subject to income taxes in the PRC. These China-based subsidiaries and VIEs conduct substantially all of our operations and, as a result, we generate most of our consolidated income in China. The amount of cash derived from our operations that can be used to buy back our shares of common stock in the market, paid as dividends to Sohu.com Inc.'s shareholders or used for other corporate purposes of Sohu.com Inc. may be limited by the imposition of U.S. corporate income tax on Sohu.com Inc.'s income. In accordance with U.S. GAAP, we do not provide for U.S. federal income taxes or tax benefits on the undistributed earnings or losses of our non-U.S. subsidiaries or consolidated VIEs because, for the foreseeable future, we do not have the intention to repatriate those undistributed earnings or losses to the U.S. However, certain activities conducted in the PRC may give rise to U.S. corporate income tax, even if there are no distributions to Sohu.com Inc. U.S. corporate income taxes would be imposed on Sohu.com Inc. when its subsidiaries that are controlled foreign corporations ("CFCs") generate income that is subject to Subpart F of the U.S. Internal Revenue Code ("Subpart F"). Passive income, such as rents, royalties, interest and dividends, is among the types of income subject to taxation under Subpart F. Any income taxable under Subpart F is taxable in the U.S. at federal corporate income tax rates of up 34% or 35%. Subpart F income also includes certain income from intercompany transactions between Sohu.com Inc.'s non-U.S. subsidiaries and VIEs and Changyou's non-U.S. subsidiaries and VIEs, or where Sohu.com Inc.'s non-U.S. subsidiaries or VIEs make an "investment in U.S. property," such as holding the stock in, or making a loan to, a U.S. corporation. Under a temporary provision of the U.S. tax code commonly referred to as the CFC look-through rule, Sohu.com Inc. has not had to treat dividends received by its CFC subsidiaries as Subpart F income includible in Sohu.com Inc.'s taxable income in the U.S. The CFC look-through rule, which is currently scheduled to expire for taxable years beginning after December 31, 2013, has been extended several times by the U.S. Congress. Unless further extended, the CFC look-through rule will be available for Sohu.com Inc.'s CFC subsidiaries and their VIEs only through their taxable years ending November 30, 2014. -59- -------------------------------------------------------------------------------- Table of Contents Dividend Policy The Sohu Group intends to retain all available funds and any future earnings for use in the operation and expansion of its own business, and does not anticipate paying any cash dividends on Sohu.com Inc.'s common stock or causing Changyou to pay any dividends on Changyou.com Limited's ordinary shares, including ordinary shares represented by Changyou.com Limited's ADSs, for the foreseeable future. Future cash dividends distributed by Sohu.com Inc. and Changyou.com Limited, if any, will be declared at the discretion of their respective Boards of Directors and will depend upon their future operations and earnings, capital requirements and surplus, general financial condition, contractual restrictions and such other factors as their respective Boards of Directors may deem relevant. OFF-BALANCE SHEET COMMITMENTS AND ARRANGEMENTS We have not entered into any financial guarantees or other commitments to guarantee the payment obligations of third parties, except for a $9 million restricted time deposit acting as collateral for credit facilities provided by a bank to certain Sogou employees. We are not subject to any additional potential payments other than the restricted time deposit amount, and believe that the fair value of our guarantee liability is immaterial. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder's equity, or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or that engages in leasing, hedging or product development services with us. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS None. [ Back To TMCnet.com's Homepage ]