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EXCEL - IDEA: XBRL DOCUMENT - SOHU COM INCFinancial_Report.xls
EX-10.2 - AMENDED AND RESTATED 2010 STOCK INCENTIVE PLAN - SOHU COM INCdex102.htm
EX-31.2 - RULE 13A-14(A)/15D-14(A) CERTIFICATION OF CAROL YU - SOHU COM INCdex312.htm
EX-10.1 - PROJECT COOPERATION AGREEMENT OF CHANGYOU, DATED AUGUST 23, 2010 - SOHU COM INCdex101.htm
EX-10.3 - COOPERATION AGREEMENT, DATED SEPTEMBER 30, 2010 - SOHU COM INCdex103.htm
EX-32.1 - SECTION 1350 CERTIFICATION OF CHARLES ZHANG - SOHU COM INCdex321.htm
EX-31.1 - RULE 13A-14(A)/15D-14(A) CERTIFICATION OF CHARLES ZHANG - SOHU COM INCdex311.htm
EX-32.2 - SECTION 1350 CERTIFICATION OF CAROL YU - SOHU COM INCdex322.htm

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2010

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER 0-30961

 

 

Sohu.com Inc.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 

 

 

Delaware   98-0204667

(STATE OR OTHER JURISDICTION OF

INCORPORATION OR ORGANIZATION)

 

(I.R.S. EMPLOYER

IDENTIFICATION NUMBER)

Level 12, Sohu.com Internet Plaza

No. 1 Unit Zhongguancun East Road, Haidian District

Beijing 100084

People’s Republic of China

(011) 8610-6272-6666

(Address, including zip code, of registrant’s principal executive offices

and registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨


 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨    Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 

Class

 

Outstanding at September 30, 2010

Common stock, $.001 par value   37,937,980

 

 

 


 

SOHU.COM INC.

Table of Contents

 

          PAGE  

PART I

   FINANCIAL INFORMATION   

Item 1

   Condensed Consolidated Financial Statements (unaudited)      2   
   Condensed Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009      2   
  

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2010 and 2009

     3   
   Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2010 and 2009      4   
  

Condensed Consolidated Statements of Changes in Equity for the Nine Months Ended September 30, 2010 and 2009

     5   
   Notes to Condensed Consolidated Financial Statements      7   

Item 2

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      33   

Item 3

   Quantitative and Qualitative Disclosures about Market Risk      59   

Item 4

   Controls and Procedures      60   

PART II

   OTHER INFORMATION   

Item 1

   Legal Proceedings      60   

Item 1A

   Risk Factors      61   

Item 2

   Unregistered Sales of Equity Securities and Use of Proceeds      61   

Item 3

   Defaults Upon Senior Securities      61   

Item 4

   (Removed and Reserved)      61   

Item 5

   Other Information      61   

Item 6

   Exhibits      61   
   Signatures   
   Exhibit Index   

 

1


 

PART I—FINANCIAL INFORMATION

 

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SOHU.COM INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)

(In thousands, except par value)

 

     As of  
     September 30,
2010
    December 31,
2009
 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 534,662      $ 563,782   

Investment in debt securities

     74,615        0   

Accounts receivable, net

     70,102        46,610   

Prepaid and other current assets

     19,866        10,781   
                

Total current assets

     699,245        621,173   

Fixed assets, net

     119,207        115,088   

Goodwill

     67,736        55,555   

Intangible assets, net

     13,478        7,933   

Prepaid non-current assets

     138,992        26,207   

Other assets, net

     7,963        2,317   
                

Total assets

   $ 1,046,621      $ 828,273   
                

LIABILITIES AND SHAREHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 7,475      $ 4,602   

Accrued liabilities to suppliers and agents

     57,907        41,103   

Receipts in advance and deferred revenue

     49,555        36,944   

Accrued salary and benefits

     31,258        28,860   

Tax payables

     24,044        21,953   

Other accrued liabilities

     22,986        17,035   
                

Total current liabilities

     193,225        150,497   
                

Contingent consideration

     1,343        0   
                

Total liabilities

     194,568        150,497   
                

Commitments and contingencies

    

Shareholders’ equity

    

Sohu.com Inc. shareholders’ equity:

    

Common stock: $0.001 par value per share (75,400 shares authorized; 37,938 and 37,749 shares issued and outstanding, respectively)

     43        43   

Additional paid-in capital

     331,466        317,052   

Treasury stock (5,389 shares)

     (114,690     (114,690

Accumulated other comprehensive income

     30,890        21,502   

Retained earnings

     490,527        385,874   
                

Total Sohu.com Inc. shareholders’ equity

     738,236        609,781   
                

Noncontrolling interest

     113,817        67,995   
                

Total shareholders’ equity

     852,053        677,776   
                

Total liabilities and shareholders’ equity

   $ 1,046,621      $ 828,273   
                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

2


 

SOHU.COM INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)

(In thousands, except per share data)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  

Revenues:

        

Advertising:

        

Brand advertising

   $ 59,083      $ 48,502      $ 151,757      $ 131,197   

Sponsored search

     5,367        2,292        12,092        5,623   
                                

Subtotal of advertising revenues

     64,450        50,794        163,849        136,820   
                                

Online game

     85,623        68,684        235,416        196,887   

Wireless and others

     13,991        17,107        40,350        45,701   
                                

Total revenues

     164,064        136,585        439,615        379,408   

Cost of revenues:

        

Advertising:

        

Brand advertising

     23,256        15,418        62,795        43,213   

Sponsored search

     3,803        2,728        10,223        7,291   
                                

Subtotal of cost of advertising revenues

     27,059        18,146        73,018        50,504   
                                

Online game

     8,537        4,713        20,929        12,086   

Wireless and others

     7,580        10,331        20,976        26,972   
                                

Total cost of revenues

     43,176        33,190        114,923        89,562   
                                

Gross profit

     120,888        103,395        324,692        289,846   

Operating expenses:

        

Product development

     19,454        14,531        51,853        42,482   

Sales and marketing

     25,410        25,457        78,025        68,093   

General and administrative

     10,619        10,721        29,886        27,823   

Amortization of intangible assets

     163        93        410        295   
                                

Total operating expenses

     55,646        50,802        160,174        138,693   
                                

Operating profit

     65,242        52,593        164,518        151,153   

Other (expense) income

     (939     40        (1,294     103   

Interest income and exchange difference

     1,050        1,469        3,207        3,865   
                                

Income before income tax expense

     65,353        54,102        166,431        155,121   

Income tax expense

     (11,340     (7,022     (25,632     (21,577
                                

Income from continuing operations

     54,013        47,080        140,799        133,544   

Gain from discontinued e-commerce operations

     0        0        0        446   
                                

Net income

     54,013        47,080        140,799        133,990   

Less: Net income attributable to the noncontrolling interest

     13,004        9,726        36,146        18,506   
                                

Net income attributable to Sohu.com Inc.

   $ 41,009      $ 37,354      $ 104,653      $ 115,484   
                                

Basic net income per share attributable to Sohu.com Inc.

   $ 1.08      $ 0.97      $ 2.77      $ 3.02   
                                

Shares used in computing basic net income per share attributable to Sohu.com Inc.

     37,896        38,410        37,832        38,286   
                                

Diluted net income per share attributable to Sohu.com Inc.

   $ 1.01      $ 0.88      $ 2.55      $ 2.82   
                                

Shares used in computing diluted net income per share attributable to Sohu.com Inc.

     38,377        39,082        38,370        38,985   
                                

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

3


 

SOHU.COM INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

(In thousands)

 

     Nine Months Ended September 30,  
     2010      2009  

Cash flows from operating activities:

     

Net income

   $ 140,799       $ 133,990   

Adjustments to reconcile net income to net cash provided by operating activities:

     

Depreciation

     15,320         12,007   

Share-based compensation expense

     19,542         13,385   

Amortization of intangible assets and other assets

     2,899         1,355   

Provision for allowance for doubtful accounts

     88         393   

(Excess tax benefits) Reversal of excess tax benefits from share-based payment arrangements

     (1,888      678   

Others

     832         309   

Changes in assets and liabilities, net of acquisition:

     

Prepaid and other current assets

     (8,449      15,753   

Accounts receivable

     (19,002      (23,167

Tax payables

     2,578         1,225   

Accrued liabilities to suppliers and agents

     16,804         5,990   

Receipts in advance and deferred revenue

     8,413         4,098   

Accounts payable

     2,873         2,485   

Other accrued liabilities

     3,308         (76
                 

Net cash provided by operating activities

     184,117         168,425   

Cash flows from investing activities:

     

Purchase of fixed assets

     (125,522      (18,167

Purchase of debt securities

     (74,615      0   

Purchase of intangible and other assets

     (5,305      (319

Decrease in restricted cash

     0         2,671   

Acquisitions, net of cash acquired

     (14,166      0   
                 

Net cash used in investing activities

     (219,608      (15,815

Cash flows from financing activities:

     

Issuance of common stock

     968         3,787   

Excess tax benefits (Reversal of excess tax benefits) from share-based payment arrangements

     1,888         (678

Proceeds from Changyou’s initial public offering

     0         128,340   

Other payments relating to financing activities, net

     (3,000      (1,865
                 

Net cash (used in) provided by financing activities

     (144      129,584   

Effect of exchange rate changes on cash and cash equivalents

     6,515         (266
                 

Net (decrease) increase in cash and cash equivalents

     (29,120      281,928   

Cash and cash equivalents at beginning of period

     563,782         314,425   
                 

Cash and cash equivalents at end of period

   $ 534,662       $ 596,353   
                 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

4


 

SOHU.COM INC.

 

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (unaudited)

 

Nine Months Ended September 30, 2010

(In thousands)

 

 
    Total     Comprehensive
Income
    Sohu.com Inc. Shareholders’ Equity     Noncontrolling
Interest
 
      Common
Stock
    Additional
Paid-in
Capital
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income
    Retained
Earnings
   

Beginning balance

  $ 677,776      $ 0      $ 43      $ 317,052      $ (114,690   $ 21,502      $ 385,874      $ 67,995   

Issuance of common stock

    968        0        0        968        0        0        0        0   

Share-based compensation expense

    19,542        0        0        11,558        0        0        0        7,984   

Excess tax benefits from share-based awards

    1,888        0        0        1,888        0        0        0        0   

Comprehensive income:

               

Net income

    140,799        140,799        0        0        0        0        104,653        36,146   

Other comprehensive income:

               

Foreign currency translation adjustment

    11,080        11,080        0        0        0        9,388        0        1,692   
                           

Total other comprehensive income

    11,080        11,080               
                           

Total comprehensive income

    151,879        151,879               
                           

Comprehensive income attributable to the noncontrolling interest

      (37,838            
                     

Comprehensive income attributable to Sohu.com Inc.

    $ 114,041               
                                                               

Ending balance

  $ 852,053        $ 43      $ 331,466      $ (114,690   $ 30,890      $ 490,527      $ 113,817   
                                                         

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

5


 

SOHU.COM INC.

 

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (unaudited)

 

Nine Months Ended September 30, 2009

(In thousands)

 

 
    Total     Comprehensive
Income
    Sohu.com Inc. Shareholders’ Equity     Noncontrolling
Interest
 
      Common
Stock
    Additional
Paid-in
Capital
    Treasury
Stock
    Accumulated
Other
Comprehensive
Income
    Retained
Earnings
   

Beginning balance

  $ 391,094      $ 0      $ 43      $ 201,196      $ (74,683   $ 21,349      $ 238,041      $ 5,148   

Issuance of common stock

    3,787        0        0        3,787        0        0        0        0   

Share-based compensation expense

    13,385        0        0        7,231        0        0        0        6,154   

Reversal of excess tax benefits from share-based awards

    (858     0        0        (858     0        0        0        0   

Comprehensive income:

               

Net income

    133,990        133,990        0        0        0        0        115,484        18,506   

Other comprehensive income:

               

Foreign currency translation adjustment

    311        311        0        0        0        118        0        193   
                           

Total other comprehensive income

    311        311               
                           

Total comprehensive income

    134,301        134,301               
                           

Comprehensive income attributable to the noncontrolling interest

      (18,699            
                     

Comprehensive income attributable to Sohu.com Inc.

    $ 115,602               
                     

Recognition of change in Sohu’s economic interests in Changyou

    125,375          0        100,552        0        0        0        24,823   
                                                         

Ending balance

  $ 667,084        $ 43      $ 311,908      $ (74,683   $ 21,467      $ 353,525      $ 54,824   
                                                         

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

6


SOHU.COM INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. The Company and Basis of Presentation

Nature of Operations

Sohu.com Inc. (“Sohu” or “the Company”), a Delaware corporation organized in 1996, is a leading Internet company providing comprehensive online products and services in the People’s Republic of China (the “PRC” or “China”). The Company, together with its wholly-owned and majority-owned subsidiaries and variable interest entities (collectively the “Sohu Group”) mainly offers advertising services (through brand advertising and sponsored search), online game services (through Changyou.com Limited) and wireless services through its Internet sites: sohu.com, 17173.com, focus.cn, chinaren.com, sogou.com and changyou.com.

Brand advertising and online game are the two core businesses of the Sohu Group. The brand advertising business provides advertisements on the Sohu Group’s portal matrix to advertisers who wish to build up their brand awareness online. The online game business is conducted by a majority-owned subsidiary of Sohu, Changyou.com Limited (“Changyou”), which currently operates six massively multi-player online role-playing games (“MMORPGs”), (i) Tian Long Ba Bu (“TLBB”), (ii) Blade Online (“BO”), (iii) Blade Hero 2 (“BH 2”) which is the sequel to BO, (iv) Da Hua Shui Hu (“DHSH”), (v) Zhong Hua Ying Xiong (“ZHYX”) and (vi) Immortal Faith (“IF”). TLBB is Changyou’s first in-house developed MMORPG and is one of the most popular online games in China.

On April 7, 2009, Changyou completed its initial public offering on the NASDAQ Global Select Market, trading under the symbol “CYOU.” After Changyou’s offering, Sohu continues to consolidate Changyou in Sohu’s consolidated financial statements, as Sohu is Changyou’s controlling shareholder, but recognizes noncontrolling interest reflecting shares held by shareholders other than Sohu. As of September 30, 2010, 29% of the economic interest in Changyou was recognized as noncontrolling interest in Sohu’s consolidated financial statements. See Note 2—Changyou Transactions—Sohu’s Shareholding in Changyou.

Basis of Consolidation

The consolidated financial statements include the accounts of Sohu and its wholly-owned and majority-owned subsidiaries and variable interest entities (“VIEs”). VIEs are consolidated if the Company is the primary beneficiary. All intercompany transactions are eliminated.

For majority-owned subsidiaries and VIEs, noncontrolling interest is recognized to reflect the portion of their equity which is not attributable, directly or indirectly, to the controlling shareholder. As Sohu is Changyou’s controlling shareholder, Changyou’s financial results have been consolidated with those of Sohu for all periods presented. To reflect the economic interest in Changyou held by shareholders other than Sohu, Changyou’s net income attributable to these shareholders is recorded as noncontrolling interest in Sohu’s consolidated statements of operations, and Changyou’s cumulative results of operations attributable to these shareholders, along with its changes in shareholders’ equity and adjustment for share-based compensation expense in relation to those share-based awards which are unvested and vested but not yet settled, are recorded as noncontrolling interest in Sohu’s consolidated balance sheets. See Note 2—Changyou Transactions—Sohu’s Shareholding in Changyou and Note 10—Noncontrolling Interest.

 

7


 

Basis of Presentation

The accompanying unaudited condensed consolidated interim financial statements reflect all normal recurring adjustments which, in the opinion of management, are necessary for a fair statement of the results for the interim periods presented. Results for the three and nine months ended September 30, 2010 are not necessarily indicative of the results expected for the full fiscal year or for any future period. Certain comparative figures have been reclassified to conform to the current presentation.

These financial statements have been prepared in accordance with Generally Accepted Accounting Principles in the United States (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

These financial statements should be read in conjunction with the consolidated financial statements and related footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

2. Changyou Transactions

Share-based Award to Tao Wang, Chief Executive Officer of Changyou

In January 2008, Sohu communicated to and agreed with Tao Wang, who is now the Chief Executive Officer of Changyou, to grant him 700,000 ordinary shares and 800,000 restricted ordinary shares, in lieu of his contingent right in Beijing Fire Fox Digital Technology Co., Ltd. (“Beijing Fire Fox”), which was one of Sohu’s subsidiaries devoted to the development of TLBB. The 800,000 restricted ordinary shares were subject to a four-year vesting period commencing February 1, 2008. In addition, Tao Wang would not be entitled to participate in any distributions on Changyou shares, whether or not vested, until the earlier of Changyou’s completion of an initial public offering or February 2012, and in any event entitlement to distributions would be subject to vesting of the shares.

In January 2009, under Changyou’s 2008 Share Incentive Plan described below, Changyou issued 700,000 of its Class B ordinary shares and 800,000 of its Class B restricted ordinary shares to Tao Wang through Prominence Investments Ltd. (“Prominence”), which is an entity deemed under applicable Securities and Exchange Commission (“SEC”) rules to be beneficially owned by Tao Wang.

In February 2009, 200,000 Class B restricted ordinary shares held by Prominence became vested. Upon this vesting, the number of Class B ordinary shares held beneficially by Tao Wang increased to 900,000 shares and the number of Class B restricted ordinary shares held beneficially by Tao Wang decreased to 600,000 shares.

In March 2009, in preparation for its initial public offering, Changyou effected a ten-for-one share split that resulted in the aforementioned 900,000 Class B ordinary shares and 600,000 Class B restricted ordinary shares becoming 9,000,000 Class B ordinary shares and 6,000,000 Class B restricted ordinary shares, respectively.

Upon the completion of Changyou’s initial public offering in April 2009, vested Class B ordinary shares held by Prominence became entitled to participate in distributions on Changyou shares. Since the completion of the initial public offering, Class B restricted ordinary shares held by Prominence have continued, and will continue, to become vested from time to time in accordance with their terms.

 

8


 

Changyou’s 2008 Share Incentive Plan

On December 31, 2008, Changyou reserved 2,000,000 of its ordinary shares, which included 1,774,000 Class B ordinary shares and 226,000 Class A ordinary shares, for issuance to certain of its executive officers and to certain of its employees as incentive compensation under Changyou’s 2008 Share Incentive Plan. As described above, 700,000 ordinary shares and 800,000 restricted ordinary shares were granted to Tao Wang through Prominence under this incentive plan.

In March 2009, the 2,000,000 reserved ordinary shares were subject to a ten-for-one share split effected by Changyou and became 20,000,000 ordinary shares.

Initial Public Offering of Changyou

On April 7, 2009, Changyou completed its initial public offering on the NASDAQ Global Select Market, trading under the symbol “CYOU.”

The initial public offering consisted of American depositary shares (“ADSs”), with each ADS representing two Class A ordinary shares. Changyou’s ordinary shares are divided into Class A ordinary shares and Class B ordinary shares. Holders of Class A ordinary shares and holders of Class B ordinary shares have the same rights in Changyou, with the exception of voting and conversion rights. Each Class A ordinary share is entitled to one vote on all matters subject to a shareholder vote, and each Class B ordinary share is entitled to ten votes on all matters subject to a shareholder vote. Each Class B ordinary share is convertible into one Class A ordinary share at any time at the election of the holder. Class A ordinary shares are not convertible into Class B ordinary shares under any circumstances.

At the closing of the initial public offering, Changyou issued and sold 7,500,000 Class A ordinary shares represented by 3,750,000 ADSs, and Sohu, through its indirectly wholly-owned subsidiary Sohu.com (Game) Limited (“Sohu Game”), sold 9,750,000 Class A ordinary shares represented by 4,875,000 ADSs, including 2,250,000 Class A ordinary shares represented by 1,125,000 ADSs sold pursuant to the exercise of the underwriters’ over-allotment option.

Subsequent to the offering, Changyou had 102,500,000 Class A and Class B ordinary shares issued and outstanding. Those outstanding shares consisted of (i) 70,250,000 Class B ordinary shares held by Sohu through Sohu Game; (ii) 15,000,000 Class B ordinary shares held by Tao Wang through Prominence, including 6,000,000 Class B restricted ordinary shares that were not vested as of the completion of the offering; and (iii) 17,250,000 Class A ordinary shares held by public shareholders.

Net proceeds to Changyou and Sohu Game from this initial public offering were approximately $54.7 million and $70.7 million, respectively, for total proceeds of approximately $125.4 million, after deducting underwriting discounts and commissions and offering expenses.

As a result of the completion of Changyou’s initial public offering, in the second quarter of 2009, Sohu recognized a one-time gain of $100.6 million in the shareholders’ equity section of Sohu’s consolidated balance sheets, to reflect the net proceeds Sohu received from the initial public offering and the incremental change in Sohu’s economic interest in Changyou immediately before and after the offering.

Sohu’s Shareholding in Changyou

Shareholding and Control

Through September 30, 2010, 1,220,000 Class B restricted share units granted to certain of Changyou’s executive officers other than Tao Wang and to certain of its employees had become vested, and were settled in Class B ordinary shares and then converted into Class A ordinary shares; and 358,000 Class A restricted share units granted to certain of Changyou’s executive officers other than Tao Wang and to certain of its employees had become vested, and were settled in Class A ordinary shares.

 

9


 

As of September 30, 2010, Changyou had outstanding a combined total of 104,078,000 Class A and Class B ordinary shares, consisting of (i) 70,250,000 Class B ordinary shares held by Sohu through Sohu Game; (ii) 14,400,000 Class B ordinary shares held by Tao Wang through Prominence, including 4,000,000 Class B restricted ordinary shares that were not vested; (iii) 17,850,000 Class A ordinary shares issued in Changyou’s initial public offering; (iv) 1,220,000 Class A ordinary shares issued to certain of Changyou’s executive officers other than Tao Wang and to certain of its employees upon conversion of Class B ordinary shares that had been issued upon the vesting and settlement of Class B restricted share units granted to them; and (v) 358,000 Class A ordinary shares issued to certain of Changyou’s executive officers other than Tao Wang and to certain of its employees upon the vesting and settlement of Class A restricted share units granted to them.

As of September 30, 2010, treating Tao Wang’s 4,000,000 Class B restricted ordinary shares as owned by Tao Wang, Sohu held approximately 68% of the combined total of Changyou’s outstanding Class A and Class B ordinary shares and controlled approximately 81% of the total voting power in Changyou. As a result, Sohu had the power to elect the entire board of directors of Changyou and determine the outcome of all matters submitted to a shareholder vote. As Changyou’s controlling shareholder, Sohu will continue to consolidate Changyou in Sohu’s consolidated financial statements but recognize noncontrolling interest reflecting shares held by shareholders other than Sohu, as discussed above in Note 1—The Company and Basis of Presentation—Basis of Consolidation.

Economic Interest

Because Tao Wang’s 4,000,000 Class B restricted ordinary shares are subject to forfeiture to Sohu until they become vested, for accounting purposes those shares are treated as owned by Sohu, rather than as owned by Tao Wang, and therefore those shares are not included in the noncontrolling interest line items in Sohu’s consolidated financial statements. As a result, as of September 30, 2010, Sohu was treated as holding approximately 71% of the economic interest in Changyou. Accordingly, shareholders other than Sohu were treated as holding the remaining 29% of the economic interest, which was recognized as noncontrolling interest in Sohu’s consolidated financial statements, as discussed above in Note 1—The Company and Basis of Presentation—Basis of Consolidation.

Sohu’s economic interest in Changyou, as well as the noncontrolling interest recognized for Changyou in Sohu’s consolidated financial statements, will continue to change as the Class B restricted ordinary shares granted to Tao Wang become vested, and the restricted share units granted to certain of Changyou’s executive officers other than Tao Wang and to certain of its employees become vested and settled.

Dilutive Impact

Through September 30, 2010, under Changyou’s 2008 Share Incentive Plan, Changyou has granted 11,000,000 Class B ordinary shares and 4,000,000 Class B restricted ordinary shares to Tao Wang through Prominence and 4,414,000 Class A and Class B restricted share units (settleable by Changyou’s issuance of Class A ordinary shares and Class B ordinary shares, respectively) to certain of its executive officers other than Tao Wang and to certain of its employees. As of September 30, 2010, the number of Changyou’s outstanding restricted share units decreased from 4,414,000 to 2,776,250, as a result of vesting and settlement or forfeitures of restricted share units.

Because no Class A ordinary shares or Class B ordinary shares will be issued with respect to these restricted share units until the restricted share units are vested and settled, the unvested restricted share units and vested restricted share units that have not yet been settled are not included as outstanding shares of Changyou and have no impact on Sohu’s basic net income per share. Unvested restricted share units and vested restricted share units that have not yet been settled do, however, have a dilutive impact on Sohu’s diluted net income per share.

 

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For the third quarter of 2010, in the calculation of Sohu’s diluted net income per share, Sohu’s economic interest in Changyou was approximately 66%, treating all of Changyou’s existing unvested restricted shares, unvested restricted share units, and vested restricted share units that have not yet been settled as vested, in the case of restricted shares, and vested and settled, in the case of restricted shares units. See Note 11—Net Income per Share.

3. Segment Information

The Sohu Group has determined that the business segments that constitute its primary reporting segments are brand advertising, sponsored search, online game and wireless, which is consistent with the Sohu Group’s internal financial reporting structure.

Prior to 2009, the Company disclosed segment operating performance only through the gross profits line item, and did not allocate any operating expenses or assets to those segments, as management did not use this information to measure the performance of the operating segments.

Commencing January 1, 2009, the chief operating decision maker (“CODM”) began reviewing certain additional information for the online game segment. Accordingly, the Company has adjusted the online game segment operating performance measurement disclosures to include income from operations and the main segment assets for the online game segment. For the remaining segments, the operating performance measurements are unchanged. Consistent with prior periods, some items, such as share-based compensation expense, operating expenses, other income and expense, and income tax expense, are not reviewed by the CODM. These items are disclosed in the following segment information for reconciliation purposes only.

The following tables present summary information by segment (in thousands):

 

     Three Months Ended September 30, 2010  
     Segments Other Than Online Game     Online
Game
    Intercompany
Eliminations
    Consolidated  
     Brand
Advertising
    Sponsored
Search
    Wireless     Others     Segments
Other  Than
Online

Game
       

Revenues (1)

   $ 61,597      $ 5,367      $ 13,593      $ 398      $ 80,955      $ 85,624      $ (2,515   $ 164,064   

Segment cost of revenues

     (22,234     (3,802     (7,381     (199     (33,616     (8,497     0        (42,113
                                                                

Segment gross profit

   $ 39,363      $ 1,565      $ 6,212      $ 199        47,339        77,127        (2,515     121,951   
                                        

SBC (2) in cost of revenues

             (1,023     (40     0        (1,063
                                        

Gross profit

             46,316        77,087        (2,515     120,888   
                                        

Operating expenses:

                

Product development

             (7,941     (9,275     0        (17,216

Sales and marketing (1)

             (16,951     (9,703     2,515        (24,139

General and administrative

             (5,721     (2,909     0        (8,630

Amortization of intangible assets

             (138     (25     0        (163

SBC (2) in operating expenses

             (3,749     (1,749     0        (5,498
                                        

Total operating expenses

             (34,500     (23,661     2,515        (55,646
                                        

Operating profit

             11,816        53,426        0        65,242   

Other expense

             (226     (713     0        (939

Interest income and exchange difference

             7        1,043        0        1,050   

Income tax expense

             (2,876     (8,464     0        (11,340
                                        

Income from continuing operations

           $ 8,721      $ 45,292      $ 0      $ 54,013   
                                        

 

Note (1): The intercompany elimination for segment revenues mainly consists of marketing services provided by the brand advertising segment (banner advertisements etc.) to the online game segment (conducted through Changyou).
Note (2): “SBC” stands for share-based compensation expense.

 

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     Three Months Ended September 30, 2009  
     Segments Other Than Online Game                    
     Brand
Advertising
    Sponsored
Search
    Wireless     Others     Segments
Other  Than
Online

Game
    Online
Game
    Intercompany
Eliminations
    Consolidated  

Revenues (1)

   $ 52,082      $ 2,292      $ 16,788      $ 319      $ 71,481      $ 68,684      $ (3,580   $ 136,585   

Segment cost of revenues (1)

     (15,269     (2,709     (9,628     (692     (28,298     (4,545     1        (32,842
                                                                

Segment gross profit (loss)

   $ 36,813      $ (417   $ 7,160      $ (373     43,183        64,139        (3,579     103,743   
                                        

SBC (2) in cost of revenues

             (179     (169     0        (348
                                        

Gross profit

             43,004        63,970        (3,579     103,395   
                                        

Operating expenses:

                

Product development

             (7,425     (4,902     0        (12,327

Sales and marketing (1)

             (19,672     (9,212     3,579        (25,305

General and administrative

             (4,759     (4,182     0        (8,941

Amortization of intangible assets

             (92     (1     0        (93

SBC (2) in operating expenses

             (751     (3,385     0        (4,136
                                        

Total operating expenses

             (32,699     (21,682     3,579        (50,802
                                        

Operating profit

             10,305        42,288        0        52,593   

Other income

             6        34        0        40   

Interest income and exchange difference

             503        966        0        1,469   

Income tax expense

             (1,528     (5,494     0        (7,022
                                        

Income from continuing operations

           $ 9,286      $ 37,794      $ 0      $ 47,080   
                                        

 

Note (1): The intercompany elimination for segment revenues mainly consists of marketing services provided by the brand advertising segment (banner advertisements etc.) to the online game segment (conducted through Changyou).
Note (2): “SBC” stands for share-based compensation expense.

 

12


 

    Nine Months Ended September 30, 2010  
    Segments Other Than Online Game                    
    Brand
Advertising
    Sponsored
Search
    Wireless     Others     Segments
Other Than
Online
Game
    Online
Game
    Intercompany
Eliminations
    Consolidated  

Revenues (1)

  $ 159,865      $ 12,092      $ 37,954      $ 2,396      $ 212,307      $ 235,417      $ (8,109   $ 439,615   

Segment cost of revenues

    (59,602     (10,220     (20,102     (874     (90,798     (20,779     0        (111,577
                                                               

Segment gross profit

  $ 100,263      $ 1,872      $ 17,852      $ 1,522        121,509        214,638        (8,109     328,038   
                                       

SBC (2) in cost of revenues

            (3,196     (150     0        (3,346
                                       

Gross profit

            118,313        214,488        (8,109     324,692   
                                       

Operating expenses:

               

Product development

            (23,519     (21,433     0        (44,952

Sales and marketing (1)

            (51,726     (31,006     8,109        (74,623

General and administrative

            (13,968     (10,025     0        (23,993

Amortization of intangible assets

            (381     (29     0        (410

SBC (2) in operating expenses

            (9,607     (6,589     0        (16,196
                                       

Total operating expenses

            (99,201     (69,082     8,109        (160,174
                                       

Operating profit

            19,112        145,406        0        164,518   

Other expense

            (863     (431     0        (1,294

Interest income and exchange difference

            546        2,661        0        3,207   

Income tax expense

            (5,085     (20,547     0        (25,632
                                       

Income from continuing operations

          $ 13,710      $ 127,089      $ 0      $ 140,799   
                                       

 

Note (1): The intercompany elimination for segment revenues mainly consists of marketing services provided by the brand advertising segment (banner advertisements etc.) to the online game segment (conducted through Changyou).
Note (2): “SBC” stands for share-based compensation expense.

 

    Nine Months Ended September 30, 2009  
    Segments Other Than Online Game                    
    Brand
Advertising
    Sponsored
Search
    Wireless     Others     Segments
Other Than
Online
Game
    Online
Game
    Intercompany
Eliminations
    Consolidated  

Revenues (1)

  $ 148,385      $ 5,623      $ 45,117      $ 584      $ 199,709      $ 196,887      $ (17,188   $ 379,408   

Segment cost of revenues (1)

    (42,567     (7,266     (25,550     (1,410     (76,793     (11,831     12        (88,612
                                                               

Segment gross profit (loss)

  $ 105,818      $ (1,643   $ 19,567      $ (826     122,916        185,056        (17,176     290,796   
                                       

SBC (2) in cost of revenues

            (683     (267     0        (950
                                       

Gross profit

            122,233        184,789        (17,176     289,846   
                                       

Operating expenses:

               

Product development

            (20,884     (14,821     0        (35,705

 

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Sales and marketing (1)

     (54,305     (30,313     17,176        (67,442

General and administrative

     (12,593     (10,223     0        (22,816

Amortization of intangible assets

     (292     (3     0        (295

SBC (2) in operating expenses

     (2,630     (9,805     0        (12,435
                                

Total operating expenses

     (90,704     (65,165     17,176        (138,693
                                

Operating profit

     31,529        119,624        0        151,153   

Dividend income (3)

     96,800        0        (96,800     0   

Other income

     70        33        0        103   

Interest income and exchange difference

     1,352        2,513        0        3,865   

Income tax expense

     (5,233     (16,344     0        (21,577
                                

Income from continuing operations

   $ 124,518      $ 105,826      $ (96,800   $ 133,544   
                                

 

Note (1): The intercompany elimination for segment revenues mainly consists of marketing services provided by the brand advertising segment (banner advertisements etc.) to the online game segment (conducted through Changyou).
Note (2): “SBC” stands for share-based compensation expense.
Note (3): In the second quarter of 2009, Changyou declared a dividend distribution of $96.8 million to Sohu Game. Both Changyou and Sohu Game are within the Sohu Group.

 

     As of September 30, 2010  
     Segments
Other Than
Online Game
Total
     Online
Game
     Intercompany
Eliminations
    Consolidated  

Cash and cash equivalents (1)

   $ 242,636       $ 292,026       $ 0      $ 534,662   

Accounts receivable, net

     67,607         2,495         0        70,102   

Fixed assets, net

     65,366         53,841         0        119,207   

Total assets (2)

     606,962         445,886         (6,227     1,046,621   

 

Note (1): The cash and cash equivalents are mainly denominated in Renminbi (“RMB”) and in U.S. dollars. For a discussion of concentration of risk which the Company is exposed to, please refer to Note 7—Financial Instruments—Concentration of Risk.
Note (2): The intercompany elimination for segment assets mainly consists of marketing services provided by the brand advertising segment to the online game segment (conducted through Changyou).

 

     As of December 31, 2009  
     Segments
Other Than
Online Game
Total
     Online
Game
     Intercompany
Eliminations
    Consolidated  

Cash and cash equivalents (1)

   $ 336,881       $ 226,901       $ 0      $ 563,782   

Accounts receivable, net

     43,215         3,395         0        46,610   

Fixed assets, net

     65,910         49,178         0        115,088   

Total assets (2)

     544,942         289,391         (6,060     828,273   

 

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Note(1): The cash and cash equivalents are mainly denominated in RMB and in U.S. dollars. For a discussion of concentration of risk which the Company is exposed to, please refer to Note 7—Financial Instruments—Concentration of Risk.
Note(2): The intercompany elimination for segment assets mainly consists of marketing services provided by the brand advertising segment to the online game segment (conducted through Changyou).

4. Share-Based Compensation Expense

Both Sohu and Changyou 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 is recognized as costs and/or expenses in the consolidated financial statements based on the fair values of the related share-based awards on their grant dates. Share-based compensation expense is charged to the shareholders’ equity section in the consolidated balance sheets. See Note 9—Sohu.com Inc. Shareholders’ Equity—Stock Incentive Plan.

Share-based compensation expense was recognized in costs and/or expenses for the three and nine months ended September 30, 2010 and 2009, respectively, as follows (in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  

Cost of revenues

   $ 1,063       $ 348       $ 3,346       $ 950   

Product development expenses

     2,238         2,204         6,901         6,777   

Sales and marketing expenses

     1,271         152         3,402         651   

General and administrative expenses

     1,989         1,780         5,893         5,007   
                                   
   $ 6,561       $ 4,484       $ 19,542       $ 13,385   
                                   

There was no capitalized share-based compensation expense for the three and nine months ended September 30, 2010 and 2009.

Share-based compensation expense recognized for share-based awards granted by Sohu and Changyou, respectively, was as follows (in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
Share-based compensation expense    2010      2009      2010      2009  

For share-based awards granted by Sohu.com Inc.

   $ 4,806       $ 960       $ 12,889       $ 3,530   

For share-based awards granted by Changyou.com Limited

     1,755         3,524         6,653         9,855   
                                   
   $ 6,561       $ 4,484       $ 19,542       $ 13,385   
                                   

5. Income Taxes

Sohu and Changyou.com (US) Inc. are subject to income taxes in the United States (“U.S.”). The majority of the subsidiaries and VIEs of the Company are based in mainland China and are subject to income taxes in the PRC. These China-based subsidiaries and VIEs conduct substantially all of the Company’s operations, and generate most of the Company’s income.

 

15


 

The Company did not have any interest or penalties associated with tax positions for the three and nine months ended September 30, 2010, nor did the Company have any significant unrecognized uncertain tax positions as of September 30, 2010.

PRC Corporate Income Tax

Advertising Business and Wireless Business

Under the previous PRC income tax law, which expired on December 31, 2007, New and High Technology Enterprises (“NHTEs”) located in the Zhongguancun zone of Beijing (“BJ ZGC”) were exempted from income tax for three years beginning with their first year of operations and were entitled to a 50% tax reduction to 7.5% for the subsequent three years and 15% thereafter. The years during which NHTEs enjoy preferential tax rates are known as “tax holidays.”

Effective January 1, 2008, the current PRC Corporate Income Tax Law (the “CIT Law”) imposes a unified income tax rate of 25% for both domestic and wholly foreign-owned enterprises (“WFOEs”) but grants preferential tax treatments to NHTEs. Under the CIT Law, NHTEs can enjoy a preferential income tax rate of 15% for three years but need to re-apply after the end of the three-year period. The current CIT Law provides grandfathering treatment allowing NHTEs to continue to enjoy their unexpired tax holidays under the previous PRC income tax law, as long as these NHTEs continue to meet the criteria for NHTEs under the current CIT Law and were (i) qualified as NHTEs under the previous PRC income tax law, and (ii) established before March 16, 2007.

Three China-based subsidiaries, Beijing Sohu New Era Information Technology Co., Ltd. (“Sohu Era”), Beijing Sohu New Media Information Technology Co., Ltd. (“Sohu Media”) and Beijing Sogou Technology Development Co., Ltd. (“Sogou Technology”), qualified as NHTEs during the year ended December 31, 2008. These three companies will reapply for qualification in 2011. Two China-based VIEs, Beijing Sohu Internet Information Service Co., Ltd. (“Sohu Internet”) and Beijing Sogou Information Service Co., Ltd. (“Sogou Information”), qualified as NHTEs during the year ended December 31, 2009. These two companies will reapply for qualification in 2012. For the fiscal years 2009 and 2010, Sohu Era and Sohu Internet were subject to a 15% income tax rate; and Sohu Media, Sogou Technology and Sogou Information enjoyed a 7.5% income tax rate due to their unexpired tax holidays.

Online Game Business

Under the current CIT Law, a Software Enterprise can enjoy an income tax exemption for two years beginning with its first profitable year and a 50% tax reduction to a rate of 12.5% for the subsequent three years.

In 2008, the China-based subsidiary and the VIE of Changyou, Beijing AmazGame Age Internet Technology Co., Ltd. (“AmazGame”) and Beijing Gamease Age Digital Technology Co., Ltd. (“Gamease”), which are the main operating entities of Changyou, qualified as Software Enterprises. As a result, for the fiscal years 2009 and 2010, they were subject to a 50% reduction to a tax rate of 12.5%. This preferential tax treatment will expire at the end of fiscal year 2011.

PRC Withholding Tax on Dividends

The current CIT Law imposes a 10% withholding income tax for dividends distributed by foreign invested enterprises to their immediate holding companies outside China. A lower withholding tax rate will be applied if there is a tax treaty arrangement between mainland China and the jurisdiction of the foreign holding company. Distributions to holding companies in Hong Kong that satisfy certain requirements specified by PRC tax authorities, for example, will be subject to a 5% withholding tax rate.

 

16


 

In the fourth quarter of 2008, AmazGame declared a dividend to its immediate holding company in Hong Kong and a withholding tax of approximately $5.0 million was accrued based on a 5% withholding tax rate. This withholding tax was paid in the third quarter of 2009.

As of September 30, 2010, the Company had not recorded any withholding tax on the retained earnings of its foreign invested enterprises in the PRC, since the Company intends to reinvest its earnings to further expand its business in mainland China, and its foreign invested enterprises do not intend to declare dividends to their immediate foreign holding companies.

Uncertain Tax Positions

Related to PRC Corporate Income Tax

In 2009, the PRC tax bureau communicated to some subsidiaries within the Sohu Group that certain expenses should not be treated as deductible for income tax purposes under the CIT Law, although the current CIT Law is silent in that regard. The Sohu Group had treated such expense as tax deductible in previous periods. This treatment had been communicated to the tax bureau, without the Sohu Group’s receiving any objections or challenges with respect to prior PRC income tax filings. Based on the tax bureau’s current interpretation, the Sohu Group concluded that it was more likely than not that such expenses would not be allowed by the tax bureau as deductions for income tax purposes. Hence, the Sohu Group recognized income tax expense of $1.2 million in the second quarter of 2009 as a result of the change in the tax bureau’s position. In addition, the Sohu Group will not reverse this treatment unless it receives a written clarification issued by the tax authority that this kind of expense is deductible for income tax purposes. The situation is unchanged as of September 30, 2010.

Since the current CIT Law was put into effect as of January 1, 2008, guidance for this law has been issued continually. In April 2010, the State Administration of Tax (“SAT”) issued a circular relating to the implementation of preferential tax treatments for NHTEs. However, to date, the Beijing local-level tax bureau has not implemented this circular and is holding the view that the relevant provisions might not apply to NHTEs in BJ ZGC. Therefore, the Company did not change its current practice. The Company expects more guidance will be issued in the future. Upon the issuance of such guidance, Sohu Group’s effective tax rate might increase.

Related to U.S. Corporate Income Tax

The U.S. Congress currently is considering legislation that, if enacted in its current form, would retroactively reinstate certain favorable provisions that expired on January 1, 2010. This legislation was not enacted prior to the issuance of the Company’s financial statements for the three and nine months ended September 30, 2010. If the expired favorable tax provisions are reinstated retroactively to January 1, 2010, the following amounts will be reversed on the Company’s financial statements in the period in which such legislation is enacted. For the three and nine months ended September 30, 2010, the Company has recognized a $0.29 million and a $0.92 million, respectively, income tax expense in its financial statements, because the above legislation has not been enacted. The accrual of this tax liability would cause a cash payment by the Company to the U.S. taxing authorities of $0.02 million and $0.05 million, respectively, based on the utilization of existing U.S. federal net operating losses generated from excess tax deductions related to share-based awards of $0.27 million and $0.87 million, respectively, for the three and nine months ended September 30, 2010. These excess tax deductions were treated under U.S. GAAP as an increase in shareholders’ equity.

 

17


 

6. Commitments and Contingencies

Contractual Obligation

On November 20, 2009, the Company entered into an agreement to purchase an office building to be built in Beijing, which will serve as the Company’s headquarters, for a purchase price of approximately $110 million denominated in RMB. On August 20, 2010, the purchase price was adjusted to $120 million to cover additional purchased floor area. As of September 30, 2010, $66 million had been paid and was recognized as prepaid non-current assets in the Company’s consolidated financial statements. The remaining $54 million payment will be settled in installments as various stages of the development plan are completed. Construction is expected to be completed by the end of 2012.

On August 23, 2010, Changyou entered into an agreement to purchase an office building to be built in Beijing, which will serve as its headquarters, for a purchase price of approximately $146 million denominated in RMB. As of September 30, 2010, $59 million had been paid and was recognized as prepaid non-current assets in the Company’s consolidated financial statements. The remaining $87 million payment will be settled in installments as various stages of the development plan are completed. Construction is expected to be completed by the end of 2012.

The Sohu Group also has some commitments related to future minimum content and service purchases, bandwidth leasing obligations, operating lease obligations, and license fees of games developed by third-parties.

Litigation

The Sohu Group is a party to various litigation matters which it considers routine and incidental to its business. Management does not expect the results of any of these actions to have a material adverse effect on the Company’s business, results of operations or financial condition.

In March 2008, the Sohu Group was sued by four major record companies, Sony BMG, Warner, Universal and Gold Label, which alleged that the Sohu Group provided music search links and download services that violated copyrights they owned. As of September 30, 2010, the lawsuits with these four record companies were still in process. At this stage, an estimation of the loss cannot be made.

Laws and Regulations

The Chinese market in which the Sohu Group operates poses certain macro-economic and regulatory risks and uncertainties. These uncertainties extend to the ability to operate an Internet business, and to conduct brand advertising, sponsored search, online game and wireless and other services in the PRC. Though the PRC has, since 1978, implemented a wide range of market-oriented economic reforms, continued reforms and progress towards a full market-oriented economy are uncertain. In addition, the telecommunication, information, and media industries remain highly regulated. Restrictions are currently in place and are unclear with respect to which segments of these industries foreign-owned entities, like the Sohu Group, may operate. The Chinese government may issue from time to time new laws or new interpretations of existing laws to regulate areas such as telecommunication, information and media.

Regulatory risks also encompass the interpretation by the tax authorities of current tax laws and regulations, including the applicability of certain preferential tax treatments. The Sohu Group’s legal structure and scope of operations in China could be subjected to restrictions, which could result in severe limits on its ability to conduct business in the PRC.

 

18


 

The Sohu Group’s sales, purchase and expense transactions are generally denominated in RMB and a significant portion of the Sohu Group’s assets and liabilities are denominated in RMB. The RMB is not freely convertible into foreign currencies. In China, foreign exchange transactions are required by law to be transacted only by authorized financial institutions. Remittances in currencies other than RMB by its subsidiaries in China may require certain supporting documentation in order to effect the remittance.

7. Financial Instruments

Fair Value of Financial Instruments

The Company’s financial instruments include cash and cash equivalents, accounts receivable, investment in debt securities, accounts payable and accrued liabilities. These financial instruments are measured at their respective fair values. For fair value measurement, U.S. GAAP establishes a three-tier hierarchy which prioritizes the inputs used in the valuation methodologies in measuring fair value:

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 marketplace.

Level 3—unobservable inputs which are supported by little or no market activity.

The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Company’s cash and cash equivalents are classified within Level 2 as they are valued using market observable inputs. The Company’s investment in debt securities is classified within Level 3 as it is valued considering the estimated future return from the investment. No gain or loss arising from the investment in debt securities was recognized during the period ended September 30, 2010.

The following table sets forth the financial instruments, measured at fair value, by level within the fair value hierarchy as of September 30, 2010 (in thousands):

 

            Fair value measurement at reporting date using  

Items

   As of
September 30,
2010
     Quoted Prices
in Active Markets
for Identical Assets
(Level 1)
     Significant Other
Observable Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Cash and cash equivalents:

           

Time deposits

   $ 267,705       $ 0       $ 267,705       $ 0   

Investment in debt securities

     74,615         0         0         74,615   
                                   

Total

   $ 342,320       $ 0       $ 267,705       $ 74,615   
                                   

 

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The following table sets forth the financial instruments, measured at fair value, by level within the fair value hierarchy as of December 31, 2009 (in thousands):

 

            Fair value measurement at reporting date using  

Items

   As of
December 31,
2009
     Quoted Prices
in Active Markets
for Identical Assets
(Level 1)
     Significant Other
Observable Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
 

Cash and cash equivalents:

           

Time deposits

   $ 308,870       $ 0       $ 308,870       $ 0   

Investment in debt securities

     0         0         0         0   
                                   

Total

   $ 308,870       $ 0       $ 308,870       $ 0   
                                   

Investment in debt securities

In September 2010, the Company purchased from a PRC-based company (the “Debtor”) for $74.6 million (equal to RMB 0.5 billion) a convertible debt security with an initial maturity of twelve months, subject to extension at the Company’s election in its sole discretion for additional sequential six-month periods, and bearing interest at the rate of 3.8% per annum, payable quarterly in cash. The Debtor’s obligations on the debt are secured by a pledge from the Debtor’s parent company of its entire equity interest in the Debtor. Under the terms of the security, if the Company continues to extend the maturity to March 31, 2014, it will have an option, exercisable on March 31, 2014, to convert the outstanding principal into fixed percentages of equity interest in two companies which are affiliates of the Debtor.

Concentration of Risk

Financial instruments that potentially subject the Company to concentrations of risk consist primarily of cash and cash equivalents, and investment in debt securities. Cash and cash equivalents in Sohu Group are mainly denominated in RMB and in U.S. dollars. Investment in debt securities are denominated in RMB. The Company may experience economic losses and negative impacts on earnings and equity as a result of exchange rate fluctuations between the U.S. dollar and the RMB. Moreover, the Chinese government imposes controls on the convertibility of RMB into foreign currencies and, in certain cases, the remittance of currency out of the PRC. The Company may experience difficulties in completing the administrative procedures necessary to obtain and remit foreign currency.

8. Variable Interest Entities

To satisfy PRC laws and regulations, the Company conducts certain business in the PRC through its VIEs. The Company consolidates all of its wholly-owned and majority-owned VIEs, of which the Company is the primary beneficiary, in its consolidated financial statements. The Company has one VIE where the Company is not the primary beneficiary, and this VIE is not consolidated in the Company’s consolidated financial statements.

Consolidated VIEs within the Sohu Group

The consolidated VIEs are directly or indirectly owned by Dr. Charles Zhang (“Dr. Zhang”), the Company’s Chairman, Chief Executive Officer and a major shareholder, and certain executive officer and employees of the Sohu Group. Capital for these VIEs was funded by the Sohu Group through loans provided to Dr. Zhang and those executive officer and employees, and was initially recorded as loans to related parties. These loans are eliminated for accounting purposes against the capital of the VIEs upon consolidation.

 

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Under contractual agreements with the Sohu Group, Dr. Zhang and those executive officer and employees of the Sohu Group who are shareholders of the VIEs are required to transfer their ownership in these entities to the Sohu Group, if permitted by PRC laws and regulations, or, if not so permitted, to designees of the Sohu Group at any time to repay the loans outstanding. All voting rights of the VIEs are assigned to the Sohu Group, and the Sohu Group has the right to designate all directors and senior management personnel of the VIEs, also has the obligation to absorb losses of the VIEs. Dr. Zhang and those executive officer and employees of the Sohu Group who are shareholders of the VIEs have pledged their shares in the VIEs as collateral for the loans. As of September 30, 2010, the aggregate amount of these loans was $13.5 million.

As of September 30, 2010, the total assets for the consolidated VIEs were $124.1 million, mainly comprising cash and cash equivalents, accounts receivable and fixed assets. As of September 30, 2010, the total liabilities for the consolidated VIEs were $60.3 million, mainly comprising accrued salary and benefits and tax payables. These balances are reflected in Sohu’s consolidated financial statements with intercompany transactions eliminated.

The following is a summary of the consolidated VIEs within the Sohu Group:

For Advertising Business

Brand Advertising Business

 

  a) Sohu Entertainment

Beijing Sohu Entertainment Culture Media Co., Ltd. (“Sohu Entertainment”) was incorporated in the PRC in 2002 and is engaged in entertainment and advertising business in the PRC. As of September 30, 2010, the registered capital of Sohu Entertainment was $1.2 million. Xin Wang (Belinda Wang), the Company’s Co-President and Chief Operating Officer, and another employee of the Sohu Group, hold 80% and 20% interests, respectively, in this entity.

 

  b) Donglin

Beijing Sohu Donglin Advertising Co., Ltd. (“Donglin”) was incorporated in the PRC in 2010 and is engaged in advertising services in the PRC. As of September 30, 2010, the registered capital of Donglin was $1.5 million. High Century and Sohu Internet each holds a 50% interest in this entity.

 

  c) Pilot New Era

Beijing Pilot New Era Advertising Co., Ltd. (“Pilot New Era”) was incorporated in the PRC in 2010 and is engaged in advertising services in the PRC. As of September 30, 2010, the registered capital of Pilot New Era was $0.7 million. High Century and Sohu Internet each holds a 50% interest in this entity.

Sponsored Search Business

 

  d) Tu Xing Tian Xia

Beijing Tu Xing Tian Xia Information Consultancy Co., Ltd. (“Tu Xing Tian Xia”) was incorporated in the PRC in 1999 and is engaged in mapping services in the PRC. As of September 30, 2010, the registered capital of Tu Xing Tian Xia was $0.2 million. High Century and Sohu Internet hold 56.1% and 43.9% interests, respectively, in this entity.

 

  e) Sogou Information

Sogou Information was incorporated in the PRC in 2005 and is engaged in providing Internet information services in the PRC. As of September 30, 2010, the registered capital of Sogou Information was $2.5 million. Two employees of the Sohu Group each hold a 50% interest in this entity.

 

21


 

For Online Game Business

 

  f) Gamease

Gamease was incorporated in the PRC in August 2007. Gamease’s primary beneficiary is AmazGame, which is an indirect subsidiary of Changyou and Sohu. As of September 30, 2010, the registered capital of Gamease was $1.3 million. Tao Wang, Chief Executive Officer of Changyou, and a Changyou employee hold 60% and 40% interests, respectively, in this entity.

 

  g) Shanghai ICE

Shanghai ICE Information Technology Co., Ltd. (“Shanghai ICE”) was incorporated in the PRC in April 2005. Shanghai ICE’s primary beneficiary is ICE Information Technology (Shanghai) Co., Ltd. (“ICE WFOE”), which is an indirect subsidiary of Changyou and Sohu. Shanghai ICE and ICE WFOE were acquired by Changyou in May 2010. As of September 30, 2010, the registered capital of Shanghai ICE was $1.2 million. Two employees of Changyou each hold a 50% interest in this entity.

 

  h) Guanyou Gamespace

Guanyou Gamespace was incorporated in the PRC in August 2010. Guanyou Gamespace’s primary beneficiary is Beijing Changyou Gamespace Software Technology Co., Ltd., which is an indirect subsidiary of Changyou and Sohu. As of September 30, 2010, the registered capital of Guanyou Gamespace was $1.5 million. Tao Wang, Chief Executive Officer of Changyou, and Dewen Chen, President and Chief Operating Officer of Changyou hold 60% and 40% interests, respectively, in this entity.

For Wireless and Others Businesses

 

  i) Sohu Internet

Sohu Internet was incorporated in the PRC in 2003 and is engaged in Internet information, wireless and advertising services in the PRC. As of September 30, 2010, the registered capital of Sohu Internet was $14.9 million. High Century and Sohu Entertainment hold 75% and 25% interests, respectively, in this entity.

 

  j) GoodFeel

Beijing GoodFeel Information Technology Co., Ltd. (“GoodFeel”) was incorporated in the PRC in 2001 and is engaged in value-added telecommunication services in the PRC. As of September 30, 2010, the registered capital of GoodFeel was $1.2 million. Two employees of the Sohu Group, hold 58.1% and 41.9% interests, respectively, in this entity.

 

  k) High Century

High Century was incorporated in the PRC in 2001 and is engaged in investment holding in the PRC. As of September 30, 2010, the registered capital of High Century was $4.6 million. Dr. Zhang and another employee of the Sohu Group, hold 80% and 20% interests, respectively, in this entity.

 

  l) 21 East Beijing

Beijing 21 East Culture Development Co., Ltd. (“21 East Beijing”) was acquired in October 2006. As of September 30, 2010, the registered capital of 21 East Beijing was $0.1 million. High Century holds a 70% interest in this entity.

 

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  m) New 21 East

New 21 East Art Development (Beijing) Co., Ltd. (“New 21 East”) was incorporated in December 2007. As of September 30, 2010, the registered capital of New 21 East is $1.4 million. High Century holds a 70% interest in this entity.

VIE Not Consolidated within the Sohu Group

In the second quarter of 2010, in order to diversify Changyou’s marketing channels for its games and also as a strategic investment, Changyou acquired a 50% equity interest in a company. Although this company is a VIE, Changyou is not the primary beneficiary because Changyou is not able to direct the activities of the VIE, and therefore Changyou does not consolidate the company. The investment is being accounted for under the equity method of accounting. As of September 30, 2010, Changyou’s maximum exposure to loss as a result of its involvement with the investee is $8.8 million, which includes Changyou’s original investment of $3.9 million and funds provided for the investee’s working capital needs recognized as prepaid and other current assets in the Company’s consolidated financial statements amounting to $4.9 million.

9. Sohu.com Inc. Shareholders’ Equity

(a) Stockholder Rights Plan

Sohu adopted a stockholder rights plan (the “Plan”) in 2001. The Plan is designed to deter coercive takeover tactics, including the accumulation of shares in the open market or through private transactions, and to prevent an acquirer from gaining control of Sohu without offering a fair and adequate price and terms to all of Sohu’s stockholders. In general, the Plan vests stockholders of Sohu with rights to purchase preferred stock of Sohu at a substantial discount from those securities’ fair market value upon a person or group acquiring without the approval of the Board of Directors more than 20% of the outstanding shares of common stock of Sohu. Any person or group who triggers the purchase right distribution becomes ineligible to participate in the Plan, causing substantial dilution of such person or group’s holdings. The rights will expire on July 25, 2011.

(b) Treasury Stock

Treasury stock consists of shares repurchased by Sohu that are no longer outstanding and are held by Sohu. Treasury stock is accounted for under the cost method.

For the three and nine months ended September 30, 2010 and 2009, Sohu did not purchase any shares of its common stock.

(c) Stock Incentive Plan

Both Sohu and Changyou 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.

 

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1) Sohu.com Inc. Share-based Awards

Sohu’s 2000 Stock Incentive Plan

Sohu’s 2000 Stock Incentive Plan (the “Sohu 2000 Stock Incentive Plan”) provided for the issuance of up to 9,500,000 shares of common stock, including those issued pursuant to the exercise of share options and upon vesting and settlement of restricted share units. The maximum term of any issued stock right under the Sohu 2000 Stock Incentive Plan is ten years from the grant date. The Sohu 2000 Stock Incentive Plan expired on January 24, 2010 and a new plan was adopted on July 2, 2010. As of the expiration date, 9,128,724 shares of common stock had been issued or were subject to issuance upon the vesting and exercise of share options or the vesting and settlement of restricted share units granted under the plan.

For the three and nine months ended September 30, 2010, total share-based compensation expense recognized for awards under the Sohu 2000 Stock Incentive Plan was $4.8 million and $12.9 million, respectively. For the three and nine months ended September 30, 2009, total share-based compensation expense recognized for awards under the Sohu 2000 Stock Incentive Plan was $1.0 million and $3.5 million, respectively.

i) Summary of share option activity

A summary of share options activity under the Sohu 2000 Stock Incentive Plan as of and for the nine months ended September 30, 2010 is presented below:

 

Options

   Number Of
Shares

(in  thousands)
    Weighted
Average
Exercise
Price
     Weighted
Average
Remaining
Contractual
Life (Years)
     Aggregate
Intrinsic
Value (1)
(in thousands)
 

Outstanding at January 1, 2010

     555      $ 16.55         4.54       $ 22,625   

Exercised

     (61     15.84         

Forfeited or expired

     0           
                

Outstanding at September 30, 2010

     494        16.63         3.81         20,244   
                

Vested at September 30, 2010

     494        16.63         3.81         20,244   
                

Exercisable at September 30, 2010

     494        16.63         3.81         20,244   
                

 

Note (1): The aggregate intrinsic value in the preceding table represents the difference between Sohu’s closing stock price of $57.62 on September 30, 2010 and the exercise price of share options. The total intrinsic value of share options exercised for the nine months ended September 30, 2010 was $2.2 million.

For the three and nine months ended September 30, 2010, no compensation expense was recognized for share options because the requisite service periods for share options had ended by the end of 2009. For the three and nine months ended September 30, 2009, total share-based compensation expense recognized for share options was $0.3 million and $0.9 million, respectively.

For the three and nine months ended September 30, 2010, total cash received from the exercise of share options amounted to $0.6 million and $1.0 million, respectively. For the three and nine months ended September 30, 2009, total cash received from the exercise of share options amounted to $0.8 million and $3.8 million, respectively.

ii) Summary of restricted share unit activity

A summary of restricted share units activity under the Sohu 2000 Stock Incentive Plan as of and for the nine months ended September 30, 2010 is presented below:

 

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Restricted Share Units

   Number of
Units

(in thousands)
    Weighted-Average
Grant-Date

Fair Value
 

Unvested at January 1, 2010

     209      $ 33.41   

Granted

     731        61.23   

Vested

     (115     30.83   

Forfeited

     (72     57.02   
          

Unvested at September 30, 2010

     753        58.56   
          

Expected to vest thereafter

     616        55.83   
          

For the three and nine months ended September 30, 2010, total share-based compensation expense recognized for restricted share units was $4.8 million and $12.9 million, respectively. For the three and nine months ended September 30, 2009, total share-based compensation expense recognized for restricted share units was $0.7 million and $2.7 million, respectively.

As of September 30, 2010, there was $20.4 million of unrecognized compensation expense related to unvested restricted share units. The expense is expected to be recognized over a weighted average period of 1.2 years.

Sohu’s 2010 Stock Incentive Plan

On July 2, 2010, the Company’s shareholders approved Sohu’s 2010 Stock Incentive Plan (the “Sohu 2010 Stock Incentive Plan”), which provides for the issuance of up to 1,500,000 shares of common stock, including those issued pursuant to the vesting and settlement of restricted share units and pursuant to the exercise of share options. The maximum term of any issued stock right under the Sohu 2010 Stock Incentive Plan is ten years from the grant date. The Sohu 2010 Stock Incentive Plan will expire on July 1, 2020. As of the date of this report, no stock rights had been issued under the Sohu 2010 Stock Incentive Plan.

2) Changyou.com Limited Share-based Awards

On December 31, 2008, Changyou reserved 2,000,000 of its ordinary shares, which included 1,774,000 Class B ordinary shares and 226,000 Class A ordinary shares, for issuance to certain of its executive officers and to certain of its employees as incentive compensation under Changyou’s 2008 Share Incentive Plan (the “Changyou 2008 Share Incentive Plan”).

In March 2009, the 2,000,000 reserved ordinary shares were subject to a ten-for-one share split effected by Changyou and became 20,000,000 ordinary shares.

Through September 30, 2010, Changyou has granted under the Changyou 2008 Share Incentive Plan 11,000,000 Class B ordinary shares and 4,000,000 Class B restricted ordinary shares to Tao Wang through Prominence and 4,414,000 Class A and Class B restricted share units (settleable by Changyou’s issuance of Class A ordinary shares and Class B ordinary shares, respectively) to certain of its executive officers other than Tao Wang and to certain of its employees.

For the three and nine months ended September 30, 2010, total share-based compensation expense recognized for awards under the Changyou 2008 Share Incentive Plan was $1.8 million and $6.7 million, respectively. For the three and nine months ended September 30, 2009, total share-based compensation expense recognized for awards under the Changyou 2008 Share Incentive Plan was $3.5 million and $9.9 million, respectively.

 

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Share-based Awards granted before Changyou’s Initial Public Offering

i) Share-based Award to Tao Wang, Chief Executive Officer of Changyou

As discussed above in Note 2—Changyou Transactions, in January 2008, Sohu communicated to and agreed with Tao Wang to grant him 700,000 ordinary shares and 800,000 restricted ordinary shares, in lieu of his contingent right in Beijing Fire Fox. The difference between the fair values (“Incremental Fair Value”), of these 700,000 ordinary shares and 800,000 restricted ordinary shares and Tao Wang’s contingent right in Beijing Fire Fox was accounted for as share-based compensation expense.

In February 2009, 200,000 Class B restricted ordinary shares held by Prominence became vested. Upon this vesting, the number of Class B ordinary shares held beneficially by Tao Wang increased to 900,000 shares and the number of Class B restricted ordinary shares held beneficially by Tao Wang decreased to 600,000 shares.

On March 16, 2009, the ordinary shares described above, which had been issued as 700,000 Class B ordinary shares and 800,000 Class B restricted ordinary shares in January 2009 and had become 900,000 Class B ordinary shares and 600,000 Class B restricted ordinary shares in February 2009 as a result of vesting, became 9,000,000 Class B ordinary shares and 6,000,000 Class B restricted ordinary shares, respectively, as a result of a ten-for-one share split effected by Changyou on that date.

For the 700,000 ordinary shares, because the terms of the issuance of these ordinary shares had been approved and were communicated to and agreed with Tao Wang as of January 2, 2008, this was considered the grant date. Accordingly, the Incremental Fair Value was determined as of that date. The portion of the Incremental Fair Value related to these ordinary shares, equal to $1.8 million, was recognized as share-based compensation expense in product development expenses for the three months ended March 31, 2008.

For the 800,000 restricted ordinary shares, as a result of the modification of their vesting terms in April 2008, the portion of the Incremental Fair Value related to these shares, equal to $7.0 million, was determined in April 2008, and was accounted for as share-based compensation expense over the vesting period starting from the date of the modification, following the accelerated basis of attribution. A summary of activity for these restricted ordinary shares as of and for the nine months ended September 30, 2010 is presented below. The shares and their fair value presented in the following table have been revised on a retroactive basis to give effect to the ten-for-one share split.

 

Class B Restricted Ordinary Shares

   Number of
Shares
(in thousands)
    Weighted-Average
Grant-Date

Fair Value
 

Unvested at January 1, 2010

     6,000      $ 1.36   

Granted

     0     

Vested

     (2,000     1.36   
          

Unvested at September 30, 2010

     4,000        1.36   
          

Expected to vest thereafter

     4,000        1.36   
          

For the three and nine months ended September 30, 2010, share-based compensation expense recognized for the above-mentioned Class B restricted ordinary shares was $0.3 million and $0.9 million, respectively. For the three and nine months ended September 30, 2009, share-based compensation expense recognized for the Class B restricted ordinary shares was $0.5 million and $1.8 million, respectively.

As of September 30, 2010, there was $0.8 million of unrecognized compensation expense related to the unvested Class B restricted ordinary shares.

 

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The fair value of the ordinary shares and restricted ordinary shares was assessed using the income approach/discounted cash flow method, with a discount for lack of marketability given that the shares underlying the award were not publicly traded at the time of grant, and was determined partly in reliance on a report prepared by a qualified professional appraiser using management’s estimates and assumptions. This assessment required complex and subjective judgments regarding Changyou’s projected financial and operating results, its unique business risks, the liquidity of its ordinary shares and its operating history and prospects at the time the grants were made.

ii) Share-based Awards to Executive Officers (other than Tao Wang) and Certain Key Employees

In April 2008, Changyou approved and communicated to executive officers other than Tao Wang the grant of an aggregate of 180,000 restricted ordinary shares and to certain key employees the grant of an aggregate of 94,000 restricted share units of Changyou (settleable in ordinary shares upon vesting). These restricted ordinary shares and restricted share units were subject to vesting over a four-year period commencing on February 1, 2008, with initial vesting also subject to the listing of Changyou’s ordinary shares in an initial public offering by Changyou. The fair value of the awards at grant date was recognized in the consolidated statement of operations starting from April 2, 2009, when ADSs representing Changyou’s Class A ordinary shares were first listed on the NASDAQ Global Select Market.

On January 15, 2009, Changyou issued 180,000 Class B restricted ordinary shares to executive officers other than Tao Wang and granted 94,000 Class B restricted share units to certain key employees, the grant of which had been approved and communicated in April 2008 as described above.

On March 13, 2009, Changyou exchanged the 180,000 Class B restricted ordinary shares for Class B restricted share units (settleable in Class B ordinary shares), that otherwise have the same vesting and other terms as applied to the Class B restricted ordinary shares described above. Following the exchange, Class B restricted share units granted to executive officers other than Tao Wang and certain key employees totaled 274,000.

On March 16, 2009, the above 274,000 Class B restricted share units became 2,740,000 Class B restricted share units as a result of the ten-for-one share split effected on that date.

A summary of activity for the above Class B restricted share units as of and for the nine months ended September 30, 2010 is presented below. The shares and their fair values presented in the following table have been revised on a retroactive basis to give effect to the ten-for-one share split.

 

Class B Restricted Share Units

   Number of
Units
(in thousands)
    Weighted-Average
Grant-Date

Fair Value
 

Unvested at January 1, 2010

     2,055      $ 1.98   

Granted

     0     

Vested

     (685     1.98   

Forfeited

     0     
          

Unvested at September 30, 2010

     1,370        1.98   
          

Expected to vest thereafter

     1,370        1.98   
          

For the three and nine months ended September 30, 2010, total share-based compensation expense recognized for the above 2,740,000 Class B restricted share units was $0.2 million and $0.7 million, respectively. For the three and nine months ended September 30, 2009, total share-based compensation expense recognized for this 2,740,000 Class B restricted share units was $0.6 million and $3.7 million, respectively.

 

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As of September 30, 2010, there was $0.6 million of unrecognized share-based compensation expense related to the unvested Class B restricted share units.

The methods Changyou used to determine the fair value as of the April 2008 grant date of these Class B restricted share units were the same as the methods used for the restricted ordinary shares granted to Tao Wang as described above.

iii) Share-based Awards to Other Employees

On February 17, 2009, Changyou granted an aggregate of 45,600 Class A restricted share units (settleable in Class A ordinary shares) to certain of its employees. These restricted share units are subject to vesting over a four-year period commencing upon the completion of the listing of Changyou’s Class A ordinary shares in an initial public offering by Changyou. The grant date fair value of the awards was recognized in Sohu’s consolidated statements of operations starting from April 2, 2009, when ADSs representing Changyou’s Class A ordinary shares were first listed on the NASDAQ Global Select Market.

On March 16, 2009, the above 45,600 Class A restricted share units became 456,000 Class A restricted share units as a result of a ten-for-one share split effected on that date.

A summary of activity for the Class A restricted share units as of and for the nine months ended September 30, 2010 is presented below. The shares and fair value presented in the following table have been revised on a retroactive basis to give effect to the ten-for-one share split.

 

Class A Restricted Share Units

   Number of
Units
(in thousands)
    Weighted-Average
Grant-Date
Fair Value
 

Unvested at January 1, 2010

     432      $ 8.00   

Granted

     0     

Vested

     (108     8.00   

Forfeited

     (34     8.00   
          

Unvested at September 30, 2010

     290        8.00   
          

Expected to vest thereafter

     261        8.00   
          

For the three and nine months ended September 30, 2010, total share-based compensation expense recognized for the above 456,000 Class A restricted share units was $0.2 million and $0.8 million, respectively. For the three and nine months ended September 30, 2009, total share-based compensation expense recognized for this 456,000 Class A restricted share units was $0.4 million and $1.0 million, respectively.

As of September 30, 2010, there was $1.1 million of unrecognized share-based compensation expense related to the unvested Class A restricted share units.

The fair value of these Class A restricted share units as of the February 17, 2009 grant date was determined based on Changyou’s offering price for its initial public offering, which was $8.00 per Class A ordinary share.

 

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Share-based Awards granted after Changyou’s Initial Public Offering

As of September 30, 2010, Changyou had granted an aggregate of 1,218,000 Class A restricted share units (settleable in Class A ordinary shares) to certain of its executive officers other than Tao Wang and to certain of its employees. These Class A restricted share units are subject to vesting over a four-year period commencing on their grant dates. A summary of activity for the Class A restricted share units as of and for the nine months ended September 30, 2010 is presented below.

 

Class A Restricted Share Units

   Number of
Units
(in thousands)
    Weighted-Average
Grant-Date
Fair Value
 

Unvested at January 1, 2010

     1,200      $ 12.41   

Granted

     18        16.91   

Vested

     (300     12.41   

Forfeited

     (2     17.08   
          

Unvested at September 30, 2010

     916        12.49   
          

Expected to vest thereafter

     914        12.48   
          

For the three and nine months ended September 30, 2010, total share-based compensation expense recognized for the above 1,218,000 Class A restricted share units was $1.1 million and $4.2 million, respectively. For the three and nine months ended September 30, 2009, total share-based compensation expense recognized for this 1,218,000 Class A restricted share units was $2.0 million and $3.4 million, respectively.

As of September 30, 2010, there was $5.5 million of unrecognized compensation expense related to the unvested Class A restricted share units.

The fair value of restricted share units as of their grant date was determined based on the market price of Changyou’s ADSs on that date.

10. Noncontrolling Interest

From January 1, 2009, the Company renamed its minority interest to noncontrolling interest and reclassified it in its consolidated balance sheets from the mezzanine section between liabilities and equity to a separate line item in equity as required by U.S. GAAP. The Company also expanded disclosures in the consolidated financial statements to clearly identify and distinguish the interests of Sohu from the interests of the noncontrolling owners of its subsidiaries. The Company has applied this presentation and disclosure requirements retrospectively for all periods presented for comparability.

The Company’s majority-owned subsidiaries and VIEs which are consolidated in Sohu’s consolidated financial statements but with noncontrolling interest recognized are Changyou and 21 East Beijing and New 21 East (collectively “21 East”). As of September 30, 2010, Sohu held 71% of the economic interest in Changyou and 70% of the economic interest in 21 East.

Noncontrolling Interest in the Consolidated Balance Sheets

As of September 30, 2010 and December 31, 2009, noncontrolling interest in the consolidated balance sheets was $113.8 million and $68.0 million, respectively.

 

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       As of  
       September 30, 2010
(in thousands)
       December 31, 2009
(in thousands)
 

Changyou

     $ 113,555         $ 67,691   

21 East

       262           304   
                     

Total

     $ 113,817         $ 67,995   
                     

As of September 30, 2010 and December 31, 2009, $113.6 million and $67.7 million, respectively, noncontrolling interest was recognized in Sohu’s consolidated balance sheets, representing a 29% and a 26%, respectively, economic interest in Changyou’s net assets and reflected the reclassification of Changyou’s share-based compensation expense from shareholders’ additional paid-in capital to noncontrolling interest, as discussed in Note 1- The Company and Basis of Presentation—Basis of Consolidation.

Noncontrolling Interest in the Consolidated Statements of Operations

For the three and nine months ended September 30, 2010, noncontrolling interest in the consolidated statements of operations was $13.0 million and $36.1 million, compared with $9.7 million and $18.5 million for the three and nine months ended September 30, 2009.

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010      2009     2010     2009  

Changyou

   $ 12,999       $ 9,751      $ 36,194      $ 18,590   

21 East

     5         (25     (48     (84
                                 

Total

   $ 13,004       $ 9,726      $ 36,146      $ 18,506   
                                 

For the three months ended September 30, 2010 and 2009, $13.0 million and $9.8 million, respectively, noncontrolling interest was recognized in Sohu’s consolidated statements of operations, representing a 29% and a 26%, respectively, economic interest in Changyou attributable to shareholders other than Sohu.

11. 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 of share-based awards using the treasury stock method. Additionally, for purposes of calculating diluted net income per share, Sohu’s consolidated net income is adjusted for Changyou’s net income multiplied by the difference between:

 

  (a) the percentage of the total economic interest in Changyou held by Sohu, which was 71% for the third quarter of 2010, and

 

  (b) the percentage of the weighted average number of Changyou shares held by Sohu to the weighted average number of Changyou ordinary shares and shares issuable upon the exercise of share-based awards under the treasury stock method, which was 66% for the third quarter of 2010.

The percentage of 66% was calculated by treating all of Changyou’s existing unvested restricted shares as vested, and all unvested restricted share units and vested restricted share units that have not yet been settled as vested and settled by Changyou. Hence, Changyou’s share number increases from the basic basis to the fully diluted basis, causing the percentage of weighted average number of shares held by Sohu in Changyou, to decrease from 71% to 66%. As a result, Changyou’s net income attributable to Sohu decreased accordingly. This impact is presented as “incremental dilution from Changyou” in the table below.

 

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The following table presents the calculation of Sohu’s basic and diluted net income per share (in thousands, except per share data)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2010     2009     2010     2009  

Numerator:

        

Net income from continuing operations attributable to Sohu.com Inc.

   $ 41,009      $ 37,354      $ 104,653      $ 115,038   

Gain from discontinued e-commerce operations attributable to Sohu.com Inc.

     0        0        0        446   
                                

Net income attributable to Sohu.com Inc., basic

     41,009        37,354        104,653        115,484   

Effect of dilutive securities:

        

Incremental dilution from Changyou

     (2,355     (2,949     (6,807     (5,608
                                

Net income attributable to Sohu.com Inc., diluted

   $ 38,654      $ 34,405      $ 97,846      $ 109,876   
                                

Denominator:

        

Weighted average basic common shares outstanding

     37,896        38,410        37,832        38,286   

Effect of dilutive securities:

        

Share options and restricted share units

     481        672        538        699   
                                

Weighted average diluted common shares outstanding

     38,377        39,082        38,370        38,985   
                                

Basic net income per share attributable to Sohu.com Inc.

        

—Continuing operations

   $ 1.08      $ 0.97      $ 2.77      $ 3.01   

—Discontinued e-commerce operations

     0.00        0.00        0.00        0.01   
                                

Basic net income per share attributable to Sohu.com Inc.

   $ 1.08      $ 0.97      $ 2.77      $ 3.02   
                                

Diluted net income per share attributable to Sohu.com Inc.

        

—Continuing operations

   $ 1.01      $ 0.88      $ 2.55      $ 2.81   

—Discontinued e-commerce operations

     0.00        0.00        0.00        0.01   
                                

Diluted net income per share attributable to Sohu.com Inc.

   $ 1.01      $ 0.88      $ 2.55      $ 2.82   
                                

12. Subsequent Events

On October 22, 2010, the Company’s online search subsidiary Sogou Inc. (“Sogou”) completed the sale of newly-issued Series A Preferred Shares to Alibaba Investment Limited, a private investment subsidiary of Alibaba Group Holding Limited, China Web Search (HK) Limited, an investment vehicle of Yunfeng Fund, LP, and Photon Group Limited, the investment fund of the Company’s Chairman and Chief Executive Officer Dr. Charles Zhang, for $15 million, $9 million, and $24 million, respectively, that represent approximately 10%, 6% and 16%, respectively, of the outstanding share capital of Sogou on a fully-diluted basis. Sohu and Sogou have established a share incentive program for Sogou management and key employees as well as certain members of Sohu’s executive management. Sohu will retain approximately 53% of Sogou on a fully-diluted basis, and intends in any event to retain a majority of the outstanding share capital of Sogou on a fully-diluted basis. After the sale of newly-issued Series A Preferred Shares, Sohu will continue to consolidate Sogou in Sohu’s consolidated financial statements, as Sohu is Sogou’s controlling shareholder, but will recognize noncontrolling interest reflecting shares held by shareholders other than Sohu.

 

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13. Recently Issued Accounting Pronouncements

In October 2009, the Financial Accounting Standards Board (“FASB”) issued new guidance on revenue recognition for arrangements with multiple deliverables and certain revenue arrangements that include software elements. By providing another alternative for determining the selling price of deliverables, the guidance for arrangements with multiple deliverables will allow companies to allocate consideration in multiple deliverable arrangements in a manner that better reflects the transaction’s economics and will often result in earlier revenue recognition. The new guidance modifies the fair value requirements of previous guidance by allowing “best estimate of selling price” in addition to vendor-specific objective evidence (“VSOE”) and other vendor objective evidence (“VOE,” now referred to as “TPE,” standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted under the new guidance. The new guidance for certain revenue arrangements that include software elements removes non-software components of tangible products and certain software components of tangible products from the scope of existing software revenue guidance, resulting in the recognition of revenue similar to that for other tangible products. The new guidance is effective for fiscal years beginning on or after June 15, 2010. However, companies may adopt the guidance as early as interim periods ended September 30, 2009. The guidance may be applied either prospectively from the beginning of the fiscal year for new or materially modified arrangements or retrospectively. The Company has not early adopted the new guidance and is currently evaluating the impact on its consolidated financial statements of adopting this guidance.

 

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

As used in this report, references to “us,” “we,” “our,” “our company,” “our group,” “Sohu” and “Sohu.com” are to Sohu.com Inc. and, except where the context requires otherwise, our wholly-owned and majority-owned subsidiaries and variable interest entities (“VIEs”), Sohu.com Limited, Sohu.com (Hong Kong) Limited (“Sohu Hong Kong”), Kylie Enterprises Limited, 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, Beijing Sohu New Era Information Technology Co., Ltd. (“Sohu Era”), Beijing Sohu Interactive Software Co., Ltd. (“Sohu Software”), Go2Map Software (Beijing) Co., Ltd. (“Go2Map Software”), Beijing Sogou Technology Development Co., Ltd. (“Sogou Technology”), Beijing Sohu New Media Information Technology Co., Ltd. (“Sohu Media”), 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 New Momentum Information Technology Co., Ltd. (“Sohu New Momentum”), Wuxi Sohu New Momentum Information Investment Co., Ltd. (“Wuxi Sohu New Momentum”), Beijing Century High Tech Investment Co., Ltd. (“High Century”), Beijing Sohu Entertainment Culture Media Co., Ltd. (“Sohu Entertainment”, formerly known as Beijing Hengda Yitong Internet Technology Development Co., Ltd., or “Hengda”), Beijing Sohu Internet Information Service Co., Ltd. (“Sohu Internet”), Beijing GoodFeel Information Technology Co., Ltd. (“GoodFeel”), Beijing Tu Xing Tian Xia Information Consultancy Co., Ltd. (“Tu Xing Tian Xia”), Beijing Sogou Information Service Co., Ltd. (“Sogou Information”), Beijing 21 East Culture Development Co., Ltd. (“21 East Beijing”), New 21 East Art Development (Beijing) Co., Ltd. (“New 21 East”), Beijing Sohu Donglin Advertising Co., Ltd.(“Donglin”), Beijing Pilot New Era Advertising Co., Ltd. (“Pilot New Era”) 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 VIE of Changyou: Changyou.com HK Limited (“Changyou HK”, formerly known as TL Age Hong Kong Limited), ICE Entertainment (HongKong) 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”), Beijing AmazGame Age Internet Technology Co., Ltd. (“AmazGame”), Beijing Changyou Gamespace Software Technology Co., Ltd. (“Gamespace”), Changyou.com Korea LLC (“Changyou Korea”), ICE Information Technology (Shanghai) Co., Ltd. (“ICE WFOE”), 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”), 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, 2009 filed with the Securities and Exchange Commission (“SEC”) on February 26, 2010, as updated by Part II Item 1A of this report. Readers are cautioned not to place undue reliance on these forward-looking statements.

 

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OVERVIEW

Sohu is a leading Internet company in China, providing hundreds of millions of Chinese Internet users with news, information, video content, entertainment, and communication. We operate one of the most comprehensive matrices of Chinese language Web properties and one of the most popular online games in China. Substantially all of our operations are conducted through our indirect wholly and majority-owned China-based subsidiaries and variable interest entities (collectively the “Sohu Group”).

Our Business

Our businesses mainly consist of advertising (composed of brand advertising and sponsored search), online game (conducted through Changyou.com Limited, “Changyou”), and wireless business, among which brand advertising and online game are our two core businesses.

Starting from 2003, our online game business has developed from nascency to become one of the top massively multi-player online role-playing game (“MMORPG”) operators in China. Its success was further endorsed by the carve-out and initial public offering of our MMORPG subsidiary Changyou (NASDAQ: CYOU) in April 2009. The successful initial public offering has provided Changyou with the platform and resources to become a leading company in the MMORPG industry, and has enabled Changyou to compete head to head with first tier players. As Changyou’s controlling shareholder, Sohu continues to consolidate Changyou but recognizes noncontrolling interest reflecting shares held by shareholders other than Sohu. During the third quarter of 2010, treating all existing restricted shares as vested and restricted share units as vested and settled, Sohu owned approximately 66% of the economic interest in Changyou, with the remaining 34% of the economic interest in Changyou owned by Changyou’s shareholders other than Sohu.

Advertising Business

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

 

   

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

 

   

17173.com, a leading game information portal;

 

   

focus.cn, a top real estate Website;

 

   

chinaren.com, a leading online alumni club; and

 

   

sogou.com, an interactive proprietary search engine.

Brand Advertising Services

Brand advertising services provide advertisements on our portal Websites to companies seeking to increase their brand awareness online. Sponsored search services provide priority placements in our search directory and pay-for-click services to customers, especially small and medium-sized enterprises.

 

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Sponsored Search Services

We restructured our sponsored search business in preparation for the sale by our online search subsidiary Sogou Inc. (“Sogou”) of 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. In the restructuring, we transferred to Sogou certain assets and liabilities associated with Sogou Pinyin and Sogou Browser, and transferred to Sohu certain non-search assets and liabilities that had been held by Sogou. Sogou will remain liable for a loan payable to Sohu in the amount of $45 million, which will be payable solely from the proceeds of an initial public offering by Sogou. The loan amount consists primarily of losses historically incurred in our search business and previously funded by Sohu.

Following the closing, completed on October 22, 2010, of the sale of Series A Preferred Shares by Sogou, Alibaba, China Web and Photon hold approximately 10%, 6% and 16%, respectively, of the outstanding share capital of Sogou on a fully-diluted basis. Sohu and Sogou have established a share incentive program for Sogou management and key employees as well as certain members of Sohu’s executive management. Sohu will retain approximately 53% of Sogou on a fully-diluted basis, and intends in any event to retain a majority of the outstanding share capital of Sogou on a fully-diluted basis. As Sogou’s controlling shareholder, Sohu will continue to consolidate Sogou but will recognize noncontrolling interest reflecting shares held by shareholders other than Sohu. We believe that the introduction of strategic investors to our Sogou search business leaves our search business in a more competitive position and offers promise for future collaboration and services with China’s largest e-commerce website.

Online Game Business

Our online game business is conducted through Sohu’s majority-owned subsidiary Changyou. Changyou is a leading online game developer and operator in China as measured by the popularity of one of its games, Tian Long Ba Bu (“TLBB”). TLBB, which was launched in May 2007, was ranked by International Data Corporation (“IDC”) in 2008 as the fourth most popular online game overall in China and the second most popular online game in China among locally-developed online games. Changyou engages in the development, operation and licensing of MMORPGs, which are interactive online games that may be played simultaneously by hundreds of thousands of game players. Changyou currently operates six MMORPGs, in-house developed TLBB, and licensed Blade Online (“BO”), Blade Hero 2 (“BH 2”), Da Hua Shui Hu (“DHSH”), Zhong Hua Ying Xiong (“ZHYX”) and Immortal Faith (“IF”) from third parties. As of September 30, 2010, these games had approximately 105.2 million aggregate registered accounts. For the three months ended September 30, 2010, these games had approximately 2.6 million aggregate active paying accounts, average revenue per active paying account of Renminbi (“RMB”)214, 1.0 million aggregate peak concurrent users (“PCU”) for Changyou’s games in China.

Changyou has a diversified pipeline of games with various graphic styles, themes and features to appeal to different segments of the online game player community, including in-house developed Duke of Mount Deer (“DMD”), which received an award as one of China’s most anticipated online games.

Changyou operates its current games under the item-based revenue model, meaning that game players can play the games for free, but may choose to pay for virtual items to enhance the game-playing experience. Game players purchase prepaid game cards or game points, which are used to purchase virtual items. Changyou sells prepaid game cards to regional distributors throughout China, who in turn sub-distribute the prepaid game cards to numerous retail outlets, including Internet cafés and various Websites, newsstands, software stores, book stores and retail stores. Changyou also directly sells game points to game players through our online sales platform.

As aforementioned, on April 7, 2009 Changyou completed its initial public offering on the NASDAQ Global Select Market, trading under the symbol “CYOU.”

 

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Agreements between Sohu and Changyou

Changyou has entered into agreements with Sohu with respect to various interim and ongoing relationships between us, including a Master Transaction Agreement, a Non-Competition Agreement, and a Marketing Services Agreement. These agreements contain provisions, among others, relating to the transfer of assets and assumption of liabilities of the MMORPG business, provide cross-indemnification of liabilities arising from each other’s business, mutually limit Sohu and Changyou from competing in each other’s business, and also include a number of ongoing commercial relationships.

Wireless and Others Businesses

Our wireless and others businesses mainly consist of the wireless business, which offers value-added services for mobile phone users such as news, weather forecasts, chatting, entertainment information and mobile phone ringtone and logo downloads.

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 Generally Accepted Accounting Principles in the United States (“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. We believe that revenue recognition, share-based compensation expense recognition, income taxes and uncertain tax positions, recognition of noncontrolling interest, computation of net income per share, allowance for doubtful accounts, determination of fair value of financial instruments, accounting for investment in debt securities, VIE consolidation, assessment of impairment for long-lived assets and goodwill, and determination of functional currencies represent critical accounting policies that reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

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. For a barter transaction involving 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. No revenue from advertising-for-advertising barter transaction is recognized since the fair value cannot be reliably determined.

Advertising Revenues

Advertising revenues include revenues from brand advertising services and sponsored search services. Advertising revenue is recognized after deducting agent rebates and applicable business tax. The recognition of advertising revenue involves certain management judgments. The amount and timing of our advertising revenues could be materially different for any period if management made different judgments or utilized different estimates.

Brand Advertising Revenues

For brand advertising revenues, a contract is signed to establish the fixed price and advertising services to be provided. Based on the contracts, we provide advertisement placements on our different Website channels and/or in different formats, including but not limited to banners, links, logos, buttons, rich media and content integration.

 

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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 collectability was assessed as reasonably assured, we recognize revenue ratably over the period during which the advertising services were provided and when all other revenue recognition criteria were met. For those contracts for which collectability was assessed as not reasonably assured, we recognize revenue only when the cash was received and all other revenue recognition criteria were met. We treat all elements of advertising contracts as a single unit of accounting for revenue recognition purposes.

Sponsorship services, which is a type of brand advertising service, is similar to other brand advertising services, but generally involves larger amounts and longer contract periods. Sponsorship services may allow advertisers to sponsor a particular area on our Websites, and may include brand affiliation services and/or a larger volume of services, and may require some exclusivity or premier placements. Sponsorship services advertisement revenues are 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.

Sponsored Search Revenues

Sponsored search services mainly include priority placement services and pay-for-click services. The priority placement services are placed in our search directory and are normally provided for a fixed fee over the service period of the contract. Pay-for-click services mainly consist of displaying the text-based links of our advertisers on our Websites and our Website Alliance network. Sponsored search contracts are normally for relatively small amounts and are signed with small and medium-sized enterprises.

Revenue for priority placement services 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. Revenue for pay-for-click services is recognized on a per click basis when the users click on the displayed links. The priority of the display of text-based links is based on the bidding price of different advertisers.

Online Game Revenues

Game Operation Revenues

We earn revenues from Changyou’s current MMORPG operations by providing online services to game players pursuant to the item-based revenue model. For periods prior to the upgrading and re-launching of BO in December 2006, BO was operated under the time-based revenue model, where game players are charged based on the time they spend playing the game. Under the item-based revenue model, game players play games free of charge and are charged for purchases of virtual items.

Under both the item-based and the time-based revenue models, proceeds received from sales of prepaid cards are initially recorded as receipts in advance.

Proceeds from sale of prepaid cards to distributors are deferred when received and, for the item-based revenue model, revenue is recognized over the estimated lives of the virtual items purchased or as the virtual items are consumed. For the time-based revenue model, revenue is recognized based upon the actual usage of time units by the game players. The revenues are recorded net of business tax, sales discounts and rebates to our distributors.

 

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Under our item-based revenue model, game players can access our games free of charge, but may purchase consumable virtual items, including those with a pre-determined expiration time, such as three months, or perpetual items, such as certain costumes that stay bound to a game player for the life of the game. Revenues in relation to consumable virtual items are recognized as they are consumed, as our services in connection with these items have been fully rendered to our game players as of that time. Revenues in relation to perpetual virtual items are recognized over their estimated lives. We will provide continual online game services in connection with these perpetual virtual items until they are no longer used by our game players. We have considered the average period that game players typically play our games and other game player behavior patterns to arrive at our best estimates for the lives of these perpetual virtual items. We have also considered that the estimated lives of perpetual virtual items may be affected by various factors, including the acceptance and popularity of expansion packs, promotional events launched and market conditions. However, given the relatively short operating history of our games, and of our most popular game TLBB in particular, our estimate of the period that game players typically play our games may not accurately reflect the estimated lives of the perpetual virtual items. We have adopted a policy of assessing the estimated lives of perpetual virtual items on a quarterly basis. All paying users’ data collected since the launch of the games are used to perform the relevant assessments. Historical behavior patterns of these paying users during the period between their first log-on date and last log-on date are used to estimate the lives of perpetual virtual items. While we believe our estimates to be reasonable based on available game player information, we may revise such estimates in the future as our games’ operation periods become longer and we continue to gain more operating history and data. Any adjustments arising from changes in the estimates of the lives of perpetual virtual items would be applied prospectively on the basis that such changes are caused by new information indicating a change in the game player behavior patterns. Any changes in our estimate of lives of perpetual virtual items may result in our revenues being recognized on a basis different from prior periods’ and may cause our operating results to fluctuate.

Overseas Licensing Revenues

We also derive online game revenues from licensing our games in other countries and territories. The licensing agreements provided for two revenue streams, an initial license fee and a monthly revenue-based royalty based on monthly revenues from the games. The initial license fee consists of both a fixed amount and additional amounts receivable upon achieving certain sales targets. Since we are required to provide when-and-if-available upgrades to the licensees during the license period, both the fixed portion and the additional portion of the initial license fee are recognized as revenue ratably over the license period. The fixed portion of the initial license fee is recognized ratably over the remaining license period from the date the game is launched, and the additional portion of the initial license fee is recognized ratably over the remaining license period from the date such additional amount is certain. The monthly usage-based royalty fee is recognized when earned, provided that collectability is reasonably assured.

Wireless and Others Revenues

Our wireless and others revenues are mainly from our wireless business.

Wireless revenues are derived from a wide range of wireless products focused on entertainment, information and communications, such as short messaging services (“SMS”), Ring Back Tone (“RBT”), Wireless Application Protocol (“WAP”), multi-media messaging services (“MMS”) and interactive voice response (“IVR”). We mainly offer news, weather forecasts, chatting, entertainment information, mobile phone ring tones, and logo downloads and various other mobile related services to mobile phone users through contracts signed with third party mobile network operators.

 

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Wireless service fees are charged on a monthly or per message/download basis. Due to technical issues with the operator’s network, we might be unable to collect certain wireless service fees from an operator in certain circumstances. This un-collectability is referred to as the “failure rate,” which can vary from operator to operator. Wireless revenues are recognized in the month in which the service is performed, provided that no significant obligations remain. To recognize wireless revenue, we rely on China mobile network operators to provide us billing confirmations for the actual amount of services they have billed to their mobile customers. At the end of each reporting period, when an operator has not yet provided us monthly billing confirmations for the period, we use information generated from our internal system as well as historical data to estimate the failure rate, to estimate the amount of collectable wireless service fees and to recognize revenue. When we later receive the actual billing confirmation, we then record a true-up accounting adjustment. Although we believe we have the ability to make reasonable estimates, differences between the actual facts and our estimates may result in significant fluctuations in the amount and timing of the revenue recognized. Since 2002 when wireless revenues began representing a significant portion of our total revenues, the quarterly historical differences in our estimated revenue which was recorded in the financial statements compared to the actual revenue have ranged from an underestimation of $1,419,000 (gross margin underestimate of $654,000) to an overestimation of $340,000 (gross margin overestimate of $171,000). For the three months ended September 30, 2010, 85% of our estimated wireless revenues were confirmed by the monthly billing confirmations received from the mobile network operators. Generally, (i) within 15 to 120 days after the end of each month, we receive billing confirmations from each of the operators confirming the amount of wireless service charges billed to that operator’s mobile phone users and (ii) within 30 to 180 days after delivering billing confirmations, each operator remits the wireless service fees, net of its service fees, for the month to us.

Our management must determine whether to record our wireless revenues using the gross or net method of reporting. Determining whether revenue should be reported gross or net is based on an assessment of various factors, the primary factors being whether we are acting as the principal in offering services to the customer or whether we are acting as an agent in the transaction and the specific requirements of each contract. 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. To the extent we are acting as a principal in a transaction, we report as revenue payments received on a gross basis, and report as costs of revenue amounts attributable to services provided by mobile network operators and other vendors. To the extent we are acting as an agent in a transaction, we report on a net basis as revenue payments received less commissions and other payments to third parties. 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. The related commissions and/or other payments to third parties are recorded as costs or expenses.

Share-based Compensation Expense

Share-based compensation expense is for share-based awards, including common stock/ordinary shares, share options, restricted shares and restricted share units, granted by Sohu and Changyou to their employees and directors. Share-based compensation expense is recognized as costs and/or expenses in the consolidated financial statements based on the fair values of the related share-based awards on their grant dates.

For share-based awards granted by Sohu, 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 share-based awards granted by Changyou, 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.

 

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Share-based compensation expense for ordinary shares granted is fully recognized in the quarter during which these ordinary shares are granted. Share-based compensation expense for share options, restricted shares and restricted share units granted is recognized on an accelerated basis over the requisite service period. 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.

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.

Income Taxes and Uncertain Tax Positions

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 financial reporting and 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 (i) future reversals of existing taxable temporary differences, (ii) future profitability, and (iii) tax planning strategies.

Our deferred tax assets are related to net operating losses of Sohu that would be subject to corporate income tax in the United States (“U.S. Corporate Income Tax”), and net operating losses and temporary differences between accounting and tax basis for our China-based subsidiaries and VIEs that are subject to corporate income tax in the PRC under the CIT law (“PRC Corporate Income Tax”). Substantially all of our income is earned through China-based subsidiaries and VIEs. In the foreseeable future we do not intend to repatriate income to the United States (“U.S.”) where it would be subject to U.S. Corporate Income Tax, except that, under certain circumstances, we may repatriate to the U.S. income that will be subject to the U.S. Alternative Minimum Tax. In the foreseeable future, it is more likely than not that the deferred tax assets resulting from the net operating losses of Sohu will not be realized. Hence, we recorded a valuation allowance against our gross deferred tax assets in order to reduce the deferred tax assets to the amount that is more likely than not to be realized. If events were to occur in the future that would allow us to realize more of our deferred tax assets than the presently recorded net amount, an adjustment would be made to the deferred tax assets that would increase income for the period when those events occurred. If events were to occur in the future that would require us to realize less of our deferred tax assets than the presently recorded net amount, an adjustment would be made to the valuation allowance against deferred tax assets that would decrease income for the period when those events occurred.

Significant management judgment is required in determining income tax expense and deferred tax assets and liabilities.

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 greater than 50% likely to be realized upon settlement.

 

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Noncontrolling Interest

Noncontrolling interest (“NCI”) is the portion of economic interest in Sohu’s majority-owned subsidiaries and VIEs which is not attributable, directly or indirectly, to Sohu. Currently, the NCI in our consolidated financial statements consists of NCI for Changyou and 21 East Beijing and New 21 East (collectively “21 East”).

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 of share-based awards using the treasury stock method. Additionally, for purposes of calculating diluted net income per share, Sohu’s consolidated net income is adjusted for Changyou’s net income multiplied by the difference between:

 

  (a) the percentage of the total economic interest in Changyou held by Sohu, and

 

  (b) the percentage of the weighted average number of Changyou shares held by Sohu to the weighted average number of Changyou ordinary shares and shares issuable upon the exercise of share-based awards under the treasury stock method.

Allowance for Doubtful Accounts Receivable

Our management makes estimates of the collectability of our accounts receivable. In estimating the general allowance, many factors are considered, including but not limited to reviewing delinquent accounts receivable, performing aging analyses and customer credit analyses, 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 mobile network operators deteriorate or the mobile network operators are unable to collect fees from their end customers, resulting in their inability to make payments due to us.

Fair Value of Financial Instruments

Our financial instruments include cash and cash equivalents, accounts receivable, investment in debt securities, accounts payable and accrued liabilities. These financial instruments are measured at their respective fair values. For fair value measurement, U.S. GAAP establishes a three-tier hierarchy which prioritizes the inputs used in the valuation methodologies in measuring fair value:

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 marketplace.

Level 3—unobservable inputs which are supported by little or no market activity.

The fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

 

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Investment in debt securities

We invest our excess cash in certain debt securities of high-quality corporate issuers. Our debt securities are classified as available-for-sale and are reported at fair market values. Unrealized gains or losses, if any, will be recorded as accumulated other comprehensive income/loss in shareholders’ equity. We periodically review our debt securities and assesses whether an impairment loss other-than-temporary has occurred due to declines in fair value or other market conditions. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and take a corresponding charge to our Consolidated Statement of Operations.

VIE Consolidation

VIEs are consolidated if we determine that we are the primary beneficiary. The primary beneficiary is the entity that has both (i) the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, and (ii) the obligation to absorb losses of the VIE that could potentially be significant to the VIE.

Long-Lived Assets

Long-lived assets include fixed assets, intangible assets and prepaid non-current assets.

Fixed assets comprise computer equipment and hardware, office building, investment properties, leasehold improvements, vehicles and office furniture. 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.

Intangible assets primarily comprise computer software, domain names, trademarks, marketing rights, operating rights for licensed games and customer lists purchased from unrelated third parties. Intangible assets are recorded at cost less accumulated amortization with no residual value. Amortization of intangible assets is computed using the straight-line method over their estimated useful lives.

Prepaid non-current assets primarily include prepayments for the office buildings to be built as Sohu’s and Changyou’s headquarters before they were recognized as fixed assets; also included are prepaid content fees, prepaid license fees and rental deposits. We amortize the content fees and license fees over the terms of the related contracts.

Management’s judgment is required in the assessment of the useful lives of long-lived assets, and is required in the measurement of impairment. 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. 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 charge 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.

Assets to be disposed of are reported at the lower of the carrying value or fair value less cost to sell.

 

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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. Goodwill is not depreciated or amortized but is tested for impairment at the reporting unit level (business segment) on an annual basis, and between annual tests when an event occurs or circumstances change that could indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of goodwill with its carrying value. 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. Any impairment losses recorded in the future could have a material adverse impact on our financial condition and results of operations.

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 it 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 and VIEs in the PRC (except for Wuxi Sohu New Momentum, a PRC subsidiary set up in May 2010), the United Kingdom, Malaysia, Korea and Vietnam, respectively, are the RMB, British Pound, Malaysian Ringgit, Korean Won and Vietnam Dong, respectively. Wuxi Sohu New Momentum’s functional currency is the U.S. dollar. The functional currency of our subsidiaries in the U.S. and Hong Kong is the U.S. dollar.

Foreign Currency Translation

Assets and liabilities of our Mainland China-based subsidiaries and VIEs (not including Wuxi Sohu New Momentum) are translated into U.S. dollars, our reporting currency, at the exchange rate in effect at the balance sheet date and revenues and expenses are translated at the average exchange rates in effect during the reporting period. 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.

RESULTS OF OPERATIONS

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009

REVENUES

The following table presents our revenues by revenue source and by proportion for the periods indicated (in thousands, except percentages):

 

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    Three Months Ended September 30,     Nine Months Ended September 30,  
    2010           2009           2010 vs
2009
    2010           2009           2010 vs
2009
 

Revenues

                   

Advertising:

                   

Brand advertising

  $ 59,083        36   $ 48,502        35   $ 10,581      $ 151,757        35   $ 131,197        35   $ 20,560   

Sponsored search

    5,367        3     2,292        2     3,075        12,092        3     5,623        1     6,469   
                                                       

Subtotal of advertising revenues

    64,450          50,794          13,656        163,849          136,820          27,029   
                                                       

Online game

    85,623        52     68,684        50     16,939        235,416        54     196,887        52     38,529   

Wireless and others

    13,991        9     17,107        13     (3,116     40,350        8     45,701        12     (5,351
                                                       

Total revenues

  $ 164,064        100   $ 136,585        100   $ 27,479      $ 439,615        100   $ 379,408        100   $ 60,207   
                                                       

Total revenues were $164.1 million and $439.6 million, respectively, for the three and nine months ended September 30, 2010, as compared to $136.6 million and $379.4 million, respectively, for the corresponding periods in 2009. The increase in total revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $27.5 million, and the increase from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $60.2 million. The increase was mainly attributable to online game revenues and brand advertising revenues.

Advertising Revenues

Advertising revenues were $64.5 million and $163.8 million, respectively, for the three and nine months ended September 30, 2010, as compared to $50.8 million and $136.8 million, respectively, for the corresponding periods in 2009. The increase in advertising revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $13.7 million, and the increase from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $27.0 million. The increase was mainly attributable to brand advertising revenues.

Brand Advertising Revenues

Brand advertising revenues were $59.1 million and $151.8 million, respectively, for the three and nine months ended September 30, 2010, respectively, compared to $48.5 million and $131.2 million, respectively, for the corresponding periods in 2009. The increase in brand advertising revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $10.6 million, and the increase from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $20.6 million. The increase was mainly attributable to increased advertising resulting from our customers’ reception of our enhanced video content.

We expect brand advertising revenues to be flat or decrease slightly in the fourth quarter of 2010, compared to the third quarter of 2010.

Sponsored Search Revenues

Sponsored search services primarily include priority placements in our search directory and pay-for-click services. Revenues from pay-for-click services accounted for approximately 86% and 82%, respectively, of the total sponsored search revenues for the three and nine months ended September 30, 2010, compared to 82% and 73%, respectively, in the corresponding periods in 2009.

 

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Sponsored search revenues were $5.4 million and $12.1 million, respectively, for the three and nine months ended September 30, 2010, compared to $2.3 million and $5.6 million, respectively, for the corresponding periods in 2009. The increase in sponsored search revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $3.1 million, the increase from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $6.5 million. The increase mainly arose from pay-for-click services.

We expect sponsored search revenues to increase in the fourth quarter of 2010, compared to the third quarter of 2010, but do not expect them to represent a significant percentage of our total advertising revenues.

Online Game Revenues

Online game revenues were $85.6 million and $235.4 million, respectively, for the three and nine months ended September 30, 2010, compared to $68.7 million and $196.9 million, respectively, for the corresponding periods in 2009. The increase in online game revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $16.9 million, and the increase from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $38.5 million. The increase was mainly due to increased popularity of our flagship game, TLBB, which we launched in May 2007.

We expect online game revenues to increase in the fourth quarter of 2010, compared to the third quarter of 2010.

Revenue Sources

The following table sets forth the revenues generated from our game operations in mainland China and overseas licensing (in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  

Online game revenues:

           

Game operations revenues

   $ 83,627       $ 66,880       $ 229,401       $ 191,162   

Overseas licensing revenues

     1,996         1,804         6,015         5,725   
                                   

Total online game revenues

   $ 85,623       $ 68,684       $ 235,416       $ 196,887   
                                   

Game Operations Revenues

Our current six MMORPGs, TLBB, BO, BH 2, DHSH, ZHYX and IF, are free to play and generate revenues using the item-based revenue model through the sale of virtual items that enhance the game-playing experience. Game players can purchase virtual items, such as gems, pets, fashion items, magic medicine, riding animals, hierograms, materials, skill books and fireworks by purchasing prepaid game cards or game points. We initially operated BO under the time-based revenue model and switched to the item-based revenue model in December 2006. We report our game operations revenues after netting business taxes, sales discounts and rebates to our distributors.

Overseas Licensing Revenues

We began licensing our game TLBB to operators outside of China in 2007. As of September 30, 2010, we have launched TLBB in Vietnam, Taiwan, Hong Kong, Malaysia¸Singapore and Thailand. Under our licensing arrangements, the licensee operators pay us an initial license fee and ongoing royalties based on a percentage of revenues generated by them over the term of the license period.

 

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Revenue Collection

Game Operations

We sell virtual and physical prepaid game cards to regional distributors, who in turn sub-distribute to retail outlets, including Internet cafés, various Websites, newsstands, software stores, bookstores and retail stores. We typically collect payment from our distributors upon delivery of our prepaid game cards, but only recognize revenues as the virtual items are consumed. We generally offer a sales discount to our prepaid game card distributors based on the popularity of our games. In addition, we offer a discount to our game players who directly purchase virtual prepaid game cards and game points from our online sales system. The sales discount represents the difference between the price at which we sell prepaid game cards to distributors or game players, as the case may be, and the face value of the prepaid game cards or the equivalent of game points.

We also offer rebates in the form of credits on future purchases of prepaid game cards to distributors of our prepaid game cards. Distributors of prepaid game cards will receive a credit on future purchases of our prepaid game cards provided that the distributors meet certain preset sales conditions. Historically, most of our distributors have met the conditions required to receive these credits. Credits are in the form of free prepaid game cards.

Overseas Licensing

Our overseas licensing revenues consist of an initial license fee and ongoing revenue-based royalties. The initial license fee includes a fixed amount payable upon signing the license agreement and additional license fees payable upon achieving certain sales targets. The ongoing revenue-based royalties are generally determined based on the amount charged to game players’ accounts in a given country or region and sales of ancillary products of the game in such country or region. We typically receive ongoing revenue-based royalties on a monthly basis.

Revenue Recognition

Game Operations

Proceeds received from sales of prepaid game cards form the basis of our revenues and are recorded initially as receipts in advance. Upon activation of the prepaid game cards, proceeds are transferred from receipts in advance to deferred revenues. Proceeds received from online sales of game points directly to game players are recorded as deferred revenues. As of September 30, 2010, we had receipts in advance from distributors and deferred revenues from our game operations of $37.2 million, compared to $29.6 million as of December 31, 2009.

We recognize revenues when virtual items purchased by game players are consumed. For consumable virtual items, including those with a predetermined expiration time, revenues are recognized as they are consumed, and for perpetual virtual items, revenues are recognized over their estimated lives. In addition, prepaid game 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 revenues upon expiration of the cards. In contrast, once the prepaid game cards are activated and credited to a game player’s account, they will not expire as long as the game account remains active. We are entitled to close a game player’s account if it has been inactive for a period of 180 consecutive days. The unused balances in an inactive game player’s account are recognized as revenues when the account is closed. For the three and nine months ended September 30, 2010, revenue from expired game cards and inactive game players’ accounts was $0.2 million and $0.5 million, respectively.

 

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Overseas Licensing

For the initial license fees receivable under our overseas licensing agreements, we recognize revenues ratably over the remaining license period, during which we are obligated to provide post-sales services such as technical support and provision of updates or upgrades to the licensed games. Unrecognized initial license fees received are recorded as deferred revenues. As of September 30, 2010, such deferred revenues were $0.8 million, compared to $0.7 million as of December 31, 2009. With respect to ongoing revenue-based royalties, we recognize revenues when the revenue-based royalties are earned under the terms of the overseas licensing agreements, and the collection of such royalties is probable.

Wireless and Others Revenues

Wireless Revenues

Wireless revenues were $13.6 million and $38.0 million, respectively, for the three and nine months ended September 30, 2010, compared to $16.8 million and $45.1 million, respectively, for the corresponding periods in 2009.

We expect wireless revenues to be flat in the fourth quarter of 2010 compared to the third quarter of 2010.

Revenues for Other Services

Other services mainly consist of sales of software to third parties, provision of applications service provider (“ASP”) services, and Websites construction and maintenance. Revenues for other services were $398,000 and $2.4 million, respectively, for the three and nine months ended September 30, 2010, compared to $319,000 and $584,000, respectively, for the corresponding periods in 2009.

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 September 30,     Nine Months Ended September 30,  
     2010            2009            2010 vs
2009
    2010            2009            2010 vs
2009
 

Cost of revenues

                        

Advertising:

                        

Brand advertising

   $ 23,256         54   $ 15,418         47   $ 7,838      $ 62,795         55   $ 43,213         48   $ 19,582   

Sponsored search

     3,803         9     2,728         8     1,075        10,223         9     7,291         8     2,932   
                                                            

Subtotal of cost of advertising revenues

     27,059           18,146           8,913        73,018           50,504           22,514   
                                                            

Online game

     8,537         20     4,713         14     3,824        20,929         18     12,086         14     8,843   

Wireless and others

     7,580         17     10,331         31     (2,751     20,976         18     26,972         30     (5,996
                                                            

Total cost of revenues

   $ 43,176         100   $ 33,190         100   $ 9,986      $ 114,923         100   $ 89,562         100   $ 25,361   
                                                            

 

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Total cost of revenues was $43.2 million and $114.9 million, respectively, for the three and nine months ended September 30, 2010, compared to $33.2 million and $89.6 million, respectively, for the corresponding periods in 2009. The increase in cost of revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $10.0 million, and the increase from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $25.4 million. The increase was mainly attributable to increased cost of brand advertising revenues and increased cost of online game revenues.

Cost of Advertising Revenues

Cost of advertising revenues was $27.1 million and $73.0 million, respectively, for the three and nine months ended September 30, 2010, compared to $18.1 million and $50.5 million, respectively, for the corresponding periods in 2009. The increase in cost of advertising revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $8.9 million, and the increase from nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $22.5 million. The increase was mainly due to increased cost of brand advertising revenues.

Cost of Brand Advertising Revenues

Cost of brand advertising revenues includes salary and benefits expenses, depreciation expenses, content and license costs, bandwidth leasing costs, and revenue sharing payments to third parties.

The cost of brand advertising revenue was $23.3 million and $62.8 million, respectively, for the three and nine months ended September 30, 2010, compared to $15.4 million and $43.2 million, respectively, for corresponding periods in 2009.

The increase in cost of brand advertising revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $7.8 million. The increase was primarily attributable to investment in Sohu’s video site, mainly consisting of a $3.2 million increase in bandwidth leasing costs and a $3.0 million increase in content and license costs. In addition, the increase included a $0.9 million increase in share-based compensation expense and a $0.5 million increase in salary and benefits expenses.

The increase in cost of brand advertising revenues from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $19.6 million. The increase was primarily attributable to investment in Sohu’s video site, mainly consisted of a $7.2 million increase in bandwidth leasing costs and a $6.8 million increase in content and license costs. In addition, the increase consisted of a $2.5 million increase in share-based compensation expense, and a $1.7 million increase in salary and benefits expenses.

Our brand advertising gross margins for the three and nine months ended September 30, 2010 were 61% and 59%, respectively, as compared to 68% and 67%, respectively, for the corresponding periods in 2009. The decrease in our brand advertising gross margin was due to the growth in brand advertising revenues having been slower than the increase in cost of brand advertising revenues.

Cost of Sponsored Search Revenues

Cost of sponsored search revenues mainly consists of depreciation expenses, bandwidth leasing costs, payments to our Website Alliance and personnel costs.

 

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Cost of sponsored search revenues was $3.8 million and $10.2 million, respectively, for the three and nine months ended September 30, 2010, compared to $2.7 million and $7.3 million, respectively, for the corresponding periods in 2009. The increase in cost of sponsored search revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $1.1 million. The increase mainly consisted of a $1.0 million increase in payments to our Website Alliance. The increase from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $2.9 million. The increase mainly consisted of a $2.1 million increase in payments to our Website Alliance and a $0.9 million increase in depreciation and bandwidth leasing costs.

Cost of Online Game Revenues

Cost of online game revenues mainly consists of salary and benefits expenses and share-based compensation expense relating to the operation of our games, revenue-based royalty payments to the developers of our licensed games, bandwidth leasing and communication costs, amortization of licensing fees, depreciation expenses, and PRC business tax and value added tax (“VAT”) arising from transactions between Changyou’s subsidiary and its VIE.

The total cost of online game revenues were $8.5 million and $20.9 million, respectively, for the three and nine months ended September 30, 2010, compared to $4.7 million and $12.1 million, respectively, for the corresponding periods in 2009.

The increase in cost of online game revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $3.8 million. The increase mainly consisted of a $1.2 million increase in salary and benefits expenses, which was attributable to the increased size of our workforce; a $0.8 million increase in bandwidth leasing and communication costs due to the increased popularity of TLBB and the launch of new games; a $0.6 million increase in revenue-based royalty payments related to licensed games in operation; and a $0.5 million increase in depreciation expenses and amortization of licensing fees.

The increase in cost of online game revenues from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $8.8 million. The increase mainly consisted of a $3.2 million increase in salary and benefits expenses, which was attributable to the increased size of our workforce; a $1.4 million increase in bandwidth leasing and communication costs due to the increased popularity of TLBB; a $1.2 million increase in depreciation expenses and amortization of licensing fees; and a $1.1 million increase in revenue-based royalty payments to the developers of our licensed games in operation.

Our online game gross margin for the three and nine months ended September 30, 2010 was 90% and 91%, respectively, as compared to 93% and 94%, respectively, for the corresponding periods in 2009.

Cost of Wireless and Others Revenues

Cost of Wireless Revenues

Cost of wireless revenues consists of collection charges and transmission fees paid to mobile network operators, payments to third party wireless service alliances and content suppliers, penalties, depreciation expenses, and bandwidth leasing costs.

Cost of wireless revenues was $7.4 million and $20.1 million, respectively, for the three and nine months ended September 30, 2010, compared to $9.6 million and $25.6 million, respectively, for the corresponding periods in 2009.

The decrease in cost of wireless revenues from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $2.2 million. The decrease mainly consisted of a $1.2 million decrease in collection charges and transmission fees paid to mobile network operators, and a $1.0 million decrease in payments to third party wireless service alliances and content suppliers. The decrease was in line with wireless revenues fluctuation.

 

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The decrease from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $5.5 million. The decrease mainly consisted of a $3.4 million decrease in payments to third party wireless service alliances and content suppliers, and a $2.0 million decrease in collection charges and transmission fees paid to mobile network operators.

The collection charges and transmission fees vary between mobile network operators, mainly including (i) a gateway fee of $0.003 to $0.030 per message, depending on the volume of the monthly total wireless messages in the third quarter of 2010, unchanged from the third quarter of 2009 and (ii) a collection fee of 0% to 80% of total fees collected by mobile network operators from mobile phone users (with the residual paid to us) in the third quarter of 2010, compared to 15% to 75% in the third quarter of 2009.

Our wireless gross margin for the three and nine months ended September 30, 2010 was 46% and 47%, respectively, as compared to 43% for both of corresponding periods in 2009.

Cost of Revenues for Other Services

Cost of revenues for other services mainly consists of personnel and other expenses in connection with sales of software, provision of ASP services and construction and maintenance of Websites. Cost of revenues for other services was $0.2 million and $0.9 million, respectively, for the three and nine months ended September 30, 2010, compared to $0.7 million and $1.4 million, respectively, for the corresponding periods in 2009.

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 September 30,     Nine Months Ended September 30,  
     2010           2009           2010 vs
2009
    2010           2009           2010 vs
2009
 

Operating Expense:

                    

Product development

   $ 19,454        35   $ 14,531        29   $ 4,923      $ 51,853        32   $ 42,482        31   $ 9,371   

Sales and marketing

     25,410        46     25,457        50     (47     78,025        49     68,093        49     9,932   

General and administrative

     10,619        19     10,721        21     (102     29,886        19     27,823        20     2,063   

Amortization of intangible assets

     163        0     93        0     70        410        0     295        0     115   
                                                        

Total operating expenses:

   $ 55,646        100   $ 50,802        100   $ 4,844      $ 160,174        100   $ 138,693        100   $ 21,481   
                                                        

Total operating expenses were $55.6 million and $160.2 million, respectively, for the three and nine months ended September 30, 2010, compared to $50.8 million and $138.7 million, respectively, for the corresponding periods in 2009. The increase in operating expense from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $4.8 million, which was mainly due to increases in product development expenses. The increase from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $21.5 million, which was mainly due to increases in sales and marketing expenses and product development expenses.

 

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Product Development Expenses

Product development expenses mainly consist of personnel-related expenses incurred for enhancement to and maintenance of our Websites as well as costs associated with new product development and enhancement for existing products and services.

Product development expenses were $19.5 million and $51.9 million, respectively, for the three and nine months ended September 30, 2010, compared to $14.5 million and $42.5 million, respectively, for the corresponding periods in 2009.

The increase in product development expenses from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $4.9 million. The increase mainly consisted of a $2.6 million increase in salary and benefits expenses due to the hiring of more game engineers; a $0.7 million increase in content and license expenses; a $0.5 million increase in facility expenses; a $0.5 million increase in depreciation expenses and a $0.5 million increase in professional fees.

The increase in product development expenses from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $9.4 million. The increase mainly consisted of a $5.4 million increase in salary and benefits expenses; a $1.5 million increase in facility expenses; a $1.1 million increase in depreciation expenses; and a $0.9 million increase in professional fees.

Sales and Marketing Expenses

Sales and marketing expenses mainly consist of advertising and promotional expenditures, salary and benefits expenses, sales commissions and travel expenses.

Sales and marketing expenses were $25.4 million and $78.0 million, respectively, for the three and nine months ended September 30, 2010, compared to $25.5 million and $68.1 million, respectively, for the corresponding periods in 2009.

The decrease in sales and marketing expenses from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $47,000. The decrease was mainly due to a $3.4 million decrease in advertising and promotion expenses mainly for a Sohu branding campaign in 2009, offset by a $1.6 million increase in salary and benefits expenses, and a $1.1 million increase in share-based compensation expense primarily for restricted share units granted in January 2010.

The increase in sales and marketing expenses from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $9.9 million. The increase was mainly due to a $3.4 million increase in salary and benefits expenses; a $2.8 million increase in share-based compensation expense primarily for restricted share units granted in January 2010; and a $2.2 million increase in advertising and promotion expenses mainly for the online game business.

General and Administrative Expenses

General and administrative expenses mainly consist of salary and benefits expenses and professional service fees.

General and administrative expenses were $10.6 million and $29.9 million, respectively, for the three and nine months ended September 30, 2010, compared to $10.7 million and $27.8 million, respectively, for the corresponding periods in 2009.

 

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The decrease in general and administrative expenses from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $0.1 million.

The increase in general and administrative expenses from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $2.1 million. The increase was mainly due to a $0.9 million increase in share-based compensation expense primarily for restricted share units granted in January 2010; a $0.8 million increase in professional fees; and a $0.4 million increase in office expenses.

Amortization of Intangible Assets

Amortization of intangible assets was mainly related to the acquisitions of 17173.com, Focus.cn, GoodFeel and Go2Map.

Amortization of intangible assets was $163,000 and $410,000, respectively, for the three and nine months ended September 30, 2010, as compared to $93,000 and $295,000, respectively, for the corresponding periods in 2009.

Share-based Compensation Expense

Both Sohu and Changyou 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 and nine months ended September 30, 2010 and 2009, respectively, as follows (in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  

Cost of revenues

   $ 1,063       $ 348       $ 3,346       $ 950   

Product development expenses

     2,238         2,204         6,901         6,777   

Sales and marketing expenses

     1,271         152         3,402         651   

General and administrative expenses

     1,989         1,780         5,893         5,007   
                                   
   $ 6,561       $ 4,484       $ 19,542       $ 13,385   
                                   

Share-based compensation expense recognized for share-based awards granted by Sohu and Changyou, respectively, was as follows (in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 

Share-based compensation expense

   2010      2009      2010      2009  

For share-based awards granted by Sohu.com Inc.

   $ 4,806       $ 960       $ 12,889       $ 3,530   

For share-based awards granted by Changyou.com Limited

     1,755         3,524         6,653         9,855   
                                   
   $ 6,561       $ 4,484       $ 19,542       $ 13,385   
                                   

For share options granted by Sohu, as of September 30, 2010 there was no unrecognized compensation expense because the requisite service periods for the remaining share options had ended by the end of 2009. For restricted share units granted by Sohu, as of September 30, 2010 there was $20.4 million of unrecognized compensation expense.

 

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For share-based awards granted by Changyou, as of September 30, 2010 there was $8.1 million of unrecognized compensation expense.

Operating Profit

As a result of the foregoing, our operating profit was $65.2 million and $164.5 million, respectively, for the three and nine months ended September 30, 2010, as compared to $52.6 million and $151.2 million, respectively, for the corresponding periods in 2009.

Other (Expense) Income

Other expense was $0.9 million and $1.3 million, respectively, for the three and nine months ended September 30, 2010, as compared to other income of $40,000 and $103,000, respectively, for the corresponding periods in 2009.

Interest Income and Exchange Difference

For the three months ended September 30, 2010, interest income and exchange difference was $1.1 million, comprising interest income of $2.0 million, offset by exchange loss of $0.9 million. For the nine months ended September 30, 2010, interest income and exchange difference was $3.2 million, comprising interest income of $4.7 million, offset by exchange loss of $1.5 million. For the three and nine months ended September 30, 2009, interest income and exchange difference was $1.5 million and $3.9 million, respectively, mainly consisted of interest income.

Income Tax Expense

Income tax expense was $11.3 million and $25.6 million, respectively, for the three and nine months ended September 30, 2010, compared to $7.0 million and $21.6 million, respectively, for the corresponding periods in 2009.

The increase in income tax expense from the three months ended September 30, 2009 to the three months ended September 30, 2010 was $4.3 million. The increase was mainly due to a $2.7 million increase in income tax expense of the online game business; a $0.7 million increase in income tax expense from the utilization of excess tax benefits from existing U.S. Corporate Income Tax net operating losses generated from excess tax deductions related to share-based awards, which reduced our recognition of taxes payable in 2010 for U.S. GAAP purposes.

The increase in income tax expense from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was $4.0 million. The increase was mainly due to a $3.6 million increase in income tax expense of the online game business and a $1.9 million increase in income tax expense from the utilization of excess tax benefits from existing U.S. Corporate Income Tax net operating losses generated from excess tax deductions related to share-based awards, which reduced our recognition of taxes payable in 2010 for U.S. GAAP purposes, offset by a $1.2 million income tax expense recognized in the third quarter of 2009 as a result of a change in position by the Beijing tax bureau and a $0.5 million income tax expense reversal in the second quarter of 2010 for the 2009 annual PRC corporate income tax filing.

The $0.7 million and $1.9 million in excess tax benefits mentioned above were correspondingly treated as an increase in shareholders’ equity in the consolidated balance sheet and presented as a cash outflow from operating activities and a cash inflow from financing activities. Realizing this benefit reduced the amount of taxes payable and does not otherwise affect cash flows.

 

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Income from Continuing Operations

For the three and nine months ended September 30, 2010, the income from continuing operations was $54.0 million and $140.8 million, respectively, compared to $47.1 million and $133.5 million, respectively, for the corresponding periods of 2009.

For the three months ended September 30, 2010, we had income from continuing operations of $54.0 million, including $8.7 million from segments other than online game and $45.3 million from the online game segment. For the three months ended September 30, 2009, we had income from continuing operations of $47.1 million, including $9.3 million from segments other than online game and $37.8 million from the online game segment.

For the nine months ended September 30, 2010, we had income from continuing operations of $140.8 million, including $13.7 million from segments other than online game and $127.1 million from the online game segment. For the nine months ended September 30, 2009, we had income from continuing operations of $133.5 million, including $124.5 million from segments other than online game and $105.8 million from the online game segment, offset by a $96.8 million intercompany elimination for the dividend distribution from Changyou to Sohu Game.

Gain from Discontinued E-commerce Operations

Gain from discontinued e-commerce operations for both the three and the nine months ended September 30, 2010 was zero, and for the three and nine months ended September 30, 2009, the gain from discontinued e-commerce operation was zero and $446,000, respectively.

Net Income

As a result of the foregoing, for the three and nine months ended September 30, 2010, we had net income of $54.0 million and $140.8 million, respectively, as compared to $47.1 million and $134.0 million, respectively, for the corresponding periods of 2009.

Net Income Attributable to Noncontrolling Interest

Net income attributable to noncontrolling interest was $13.0 million and $36.1 million, respectively, for the three and nine months ended September 30, 2010, compared to $9.7 million and $18.5 million for the corresponding periods in 2009.

The increase in the noncontrolling interest from the three months ended September 30, 2009 to the three months ended September 30, 2010 was mainly due to the noncontrolling interest attributable to Changyou’s shareholders other than Sohu having increased from 26% to 29%, and Changyou’s net income also having increased during the period.

The increase in the noncontrolling interest from the nine months ended September 30, 2009 to the nine months ended September 30, 2010 was because no noncontrolling interest attributable to Changyou’s shareholders other than Sohu was recognized until Changyou’s initial public offering in April 2009.

We expect the noncontrolling interest recognized for Changyou to increase in the fourth quarter of 2010, compared to the third quarter of 2010, due to vesting of share-based awards as described in Note 9—Sohu.com Inc. Shareholders’ Equity—Changyou.com Limited Share-based Awards, as well as the increase in Changyou’s net income.

 

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Net Income attributable to Sohu.com Inc.

As a result of the foregoing, we had net income attributable to Sohu of $41.0 million and $104.7 million, respectively, for the three and nine months ended September 30, 2010, compared to $37.4 million and $115.5 million, respectively, for the corresponding periods of 2009.

LIQUIDITY AND CAPITAL RESOURCES

Our principal sources of liquidity are cash and cash equivalents, investment in debt securities, as well as cash flows generated from our operations. As of September 30, 2010, we had cash and cash equivalents of approximately $534.7 million, compared to $596.4 million as of September 30, 2009. As of September 30, 2010 and 2009, cash equivalents primarily comprise time deposits.

On November 20, 2009, we entered into an agreement to purchase an office building to be built in Beijing, which will serve as our headquarters, for a purchase price of approximately $110 million denominated in RMB. On August 20, 2010, the purchase price was adjusted to $120 million to cover additional purchased floor area. As of September 30, 2010, $66 million had been paid and was recognized as prepaid non-current assets in our consolidated financial statements. The remaining $54 million payment will be settled in installments as various stages of the development plan are completed. Construction is expected to be completed by the end of 2012.

On August 23, 2010, Changyou entered into an agreement to purchase an office building to be built in Beijing, which will serve as its headquarters, for a purchase price of approximately $146 million denominated in RMB. As of September 30, 2010, $59 million had been paid and was recognized as prepaid non-current assets in our consolidated financial statements. The remaining $87 million payment will be settled in installments as various stages of the development plan are completed. Construction is expected to be completed by the end of 2012.

We believe we will continue to generate strong cash flow from our brand advertising business and online game business, which, along with our available cash, will provide sufficient liquidity and financial flexibility.

Cash Generating Ability

Our cash flows are summarized below (in thousands):

 

     Nine Months Ended September 30,  
     2010      2009  

Net cash provided by operating activities

   $ 184,117       $ 168,425   

Net cash used in investing activities

     (219,608      (15,815

Net cash (used in) provided by financing activities

     (144      129,584   

Effect of exchange rate change on cash and cash equivalents

     6,515         (266
                 

Net (decrease) increase in cash and cash equivalents

     (29,120      281,928   

Cash and cash equivalents at beginning of period

     563,782         314,425   
                 

Cash and cash equivalents at end of period

   $ 534,662       $ 596,353   
                 

Net Cash Provided by Operating Activities

For the nine months ended September 30, 2010, $184.1 million net cash provided by operating activities was primarily attributable to our net income of $140.8 million, adjusted by non-cash items of share-based compensation expense of $19.5 million, depreciation and amortization of $18.2 million and other miscellaneous non-cash expense of $1.0 million, and an increase in cash from working capital items of $6.5 million, offset by a decrease in cash of $1.9 million excess tax benefits. In accordance with U.S. GAAP, this $1.9 million in excess tax benefits was presented as a reduction of cash flows from operating activities and a cash inflow from financing activities. Realizing this benefit reduced the amount of taxes payable and does not otherwise affect cash flows.

 

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For the nine months ended September 30, 2009, net cash provided by operating activities was $168.4 million. This was primarily attributable to our net income of $134.0 million, adjusted by non-cash items of share-based compensation expense of $13.4 million, depreciation and amortization of $13.4 million, an increase in cash from working capital items of $6.3 million and other miscellaneous non-cash expense of $1.3 million. The $6.3 million was the net impact of an $18.9 million income tax refund received in January 2009 offset by a decrease in cash from other working capital items of $12.6 million.

Net Cash Used in Investing Activities

For the nine months ended September 30, 2010, $219.6 million net cash used in investing activities was primarily attributable to $130.8 million used in acquiring fixed assets and prepaid non-current assets, including $125.2 million paid for office buildings to be built in Beijing, $74.6 million of investment in debt securities and $14.2 million used in business acquisitions.

For the nine months ended September 30, 2009, $15.8 million net cash used in investing activities was primarily attributable to $18.5 million used in acquiring fixed assets and prepaid non-current assets, offset by a $2.7 million decrease in restricted cash.

Net Cash (Used in) Provided by Financing Activities

For the nine months ended September 30, 2010, $0.1 million net cash used in financing activities was primarily attributable to repayment of a $3.0 million loan by one of Sohu’s subsidiaries to a third party, offset by $1.9 million in excess tax benefits mentioned above in “Net Cash Provided by Operating Activities,” and $1.0 million from the issuance of common stock upon the exercise of share options granted under our stock incentive plan.

For the nine months ended September 30, 2009, $129.6 million net cash provided by financing activities was primarily attributable to $128.3 million of proceeds generated from Changyou’s initial public offering after deducting underwriting discounts and commissions but before deducting offering expenses, and $3.8 million from issuance of common stock upon the exercise of options granted under our stock incentive plan, offset by $1.8 million for other financing activities payment and $0.7 million for the reversal of excess tax benefits related to share-based payment arrangements.

Cash and cash equivalents

As of September 30, 2010, we had cash and cash equivalents of approximately $534.7 million compared to $563.8 million as of December 31, 2009.

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.

Restrictions on Cash Transfers to Sohu.com Inc.

To fund any cash requirements it may have, Sohu may need to rely on dividends and other distributions on equity paid by Sohu.com Limited and Changyou, our wholly-owned subsidiary and majority-owned subsidiary. Since substantially all of our operations are conducted through our indirect China-based wholly-owned subsidiaries, majority-owned subsidiaries and VIEs, Sohu.com Limited and Changyou may need to rely on dividends, loans or advances made by our PRC subsidiaries.

 

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Substantially all of Changyou’s operations are conducted through Gamease, a VIE, which generates most of our online game revenues. As Gamease is not owned by AmazGame, Changyou’s subsidiary in China, it is not able to make dividend payments to AmazGame. Instead, AmazGame has entered into a number of contracts with Gamease to provide services to Gamease in return for cash payments. In order for us to receive any dividends, loans or advances from AmazGame through Changyou, or to distribute any dividends to our shareholders, we may need to rely on these payments made from Gamease to AmazGame. Depending on the nature of services provided by AmazGame to Gamease, certain of these payments are subject to PRC taxes, including business taxes and value added tax, which effectively reduce the amount that AmazGame receives from Gamease. In addition, the PRC government could impose restrictions on such payments or change the tax rates applicable to such payments.

In addition, 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”), are also required to set aside at least 10% of their after-tax profit based on PRC accounting standards each year to their general reserves until the cumulative amount reaches 50% of their paid-in capital. These reserves are not distributable as cash dividends, or as loans or advances. These 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 Changyou and/or to Sohu.com Limited and, accordingly, would not be available for distribution to Sohu.

Also, under regulations of the 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 China, unless prior approval of the SAFE is obtained and prior registration with the SAFE is made.

With respect to PRC tax, certain dividends paid by WFOEs to their immediate Hong Kong holding companies that meet tax authorities’ requirements would be subject to a withholding tax at the rate of 5%, which would reduce the amount of cash available for distribution to Sohu. Any such dividends paid to Hong Kong holding companies that did not meet the tax authorities’ requirements would be subject to a withholding tax at the rate of 10% which would further reduce the amount of cash available for distribution to Sohu.

With respect to U.S. tax, as Sohu Group has two listed companies, Sohu.com Inc. and Changyou.com Limited, which are regarded as separate legal entities for U.S. tax purposes, certain transactions between these two companies as well as between their subsidiaries and VIEs might expose Sohu.com Inc. to 34% or 35% U.S. Corporate Income Tax. In addition, certain transactions of Changyou and its subsidiaries and VIEs (for example, investing in U.S. properties) might also expose Sohu.com Inc. to the risk that these transactions will be treated as taxable for U.S. tax purposes. Moreover, if Changyou pays dividends, Sohu.com Inc., as one of the shareholders of Changyou, might be subject to U.S. tax at 34% or 35% for the dividends received or, under certain circumstances, when Sohu sells Changyou American depositary shares (“ADSs”) originally held by Sohu at a price higher than its U.S. tax basis, a portion of the proceeds will be subject to U.S. tax at 34% or 35%. Furthermore, any dividends or any deemed dividends received by Sohu.com Inc. would be subject to U.S. Tax at 34% or 35%.

We do not expect any of such restrictions or taxes to have a material impact on our ability to meet our cash obligations.

Dividend Policy

The two listed companies within the Sohu Group, Sohu.com Inc. and Changyou.com Limited, do not expect to pay dividends on their common stock and ordinary shares, respectively, in the foreseeable future. The Sohu Group currently intends to retain all available funds and any future earnings for use in the operation and expansion of its business, and does not anticipate paying any cash dividends on Sohu.com Inc.’s common stock or on Changyou.com Limited’s ordinary shares, including on ordinary shares represented by Changyou.com Limited’s ADSs, for the foreseeable future.

 

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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 other factors as their respective boards of directors may deem relevant.

Holders of ADSs of Changyou.com Limited will be entitled to receive dividends, subject to the terms of the deposit agreement, to the same extent as the holders of Changyou.com Limited’s ordinary shares, less the fees and expenses payable under the deposit agreement. Any cash dividends will be paid by the depositary to holders of ADSs in U.S. dollars, subject to the terms of the deposit agreement. Other distributions, if any, will be paid by the depositary to holders of ADSs in any manner that the depositary deems equitable and practicable.

On April 1, 2009, Changyou.com Limited declared a cash dividend of $96.8 million payable solely to Sohu.com (Game) Limited, which is an indirect wholly-owned subsidiary of Sohu.com Inc. In the fourth quarter of 2009, after receiving approval from the PRC government, Changyou.com Limited paid the dividend to Sohu.com (Game) Limited. Changyou.com Limited’s only other shareholder on April 1, 2009, Prominence Investments Ltd., a British Virgin Islands company beneficially owned by Tao Wang, Chief Executive Officer of Changyou, was not entitled to participate in the dividend.

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. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholders’ 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

In October 2009, the FASB issued new guidance on revenue recognition for arrangements with multiple deliverables and certain revenue arrangements that include software elements. By providing another alternative for determining the selling price of deliverables, the guidance for arrangements with multiple deliverables will allow companies to allocate consideration in multiple deliverable arrangements in a manner that better reflects the transaction’s economics and will often result in earlier revenue recognition. The new guidance modifies the fair value requirements of previous guidance by allowing “best estimate of selling price” in addition to vendor-specific objective evidence (“VSOE”) and other vendor objective evidence (“VOE,” now referred to as “TPE,” standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted under the new guidance. The new guidance for certain revenue arrangements that include software elements removes non-software components of tangible products and certain software components of tangible products from the scope of existing software revenue guidance, resulting in the recognition of revenue similar to that for other tangible products. The new guidance is effective for fiscal years beginning on or after June 15, 2010. However, companies may adopt the guidance as early as interim periods ended September 30, 2009. The guidance may be applied either prospectively from the beginning of the fiscal year for new or materially modified arrangements or retrospectively. We have not early adopted the new guidance and are currently evaluating the impact on our consolidated financial statements of adopting this guidance.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

FOREIGN CURRENCY EXCHANGE RATE RISK

While our reporting currency is the U.S. dollar, to date the majority of our revenues and costs are denominated in RMB and a significant portion of our assets and liabilities are denominated in RMB. As a result, we are exposed to foreign exchange risk as our revenues and results of operations may be affected by fluctuations in the exchange rate between the U.S. dollar and the RMB. If the RMB depreciates against the U.S. dollar, the value of our RMB revenues and assets as expressed in our U.S. dollar financial statements will decline. We do not hold any derivative or other financial instruments that expose us to substantial market risk.

The RMB is currently freely convertible under the “current account,” which includes dividends, trade and service-related foreign exchange transactions, but not under the “capital account,” which includes foreign direct investment. In addition, commencing on July 21, 2005, China reformed its exchange rate regime by changing to a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. Under the managed floating exchange rate regime, the RMB is no longer pegged to the U.S. dollar. The exchange rate of the RMB against the U.S. dollar was adjusted to RMB 8.11 per U.S. dollar as of July 21, 2005, representing an appreciation of about 2%. The People’s Bank of China will announce the closing prices of foreign currencies such as the U.S. dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market on each business day, and will make such prices the central parity for trading against the RMB on the following business day. On May 19, 2007, the People’s Bank of China announced a policy to expand the maximum daily floating range of RMB trading prices against the U.S. dollar in the inter-bank spot foreign exchange market from 0.3% to 0.5%. While the international reactions to the RMB revaluation and widening of the RMB’s daily trading band have generally been positive, with the increased floating range of the RMB’s value against foreign currencies, the RMB may appreciate or depreciate significantly in value against the U.S. dollar or other foreign currencies in the long term, depending on the fluctuation of the basket of currencies against which it is currently valued.

On June 19, 2010, the People’s Bank of China announced that it has decided to proceed further with the reform of the RMB exchange rate regime to enhance the flexibility of the RMB exchange rate and that emphasis would be placed on reflecting market supply and demand with reference to a basket of currencies. While so indicating its intention to make the RMB’s exchange rate more flexible, the People’s Bank of China ruled out any sharp fluctuations in the currency or a one-off adjustment. Shortly after this announcement, the center point of the currency’s official trading band broke through the 6.8 barrier to hit 6.7969 to the U.S. dollar, and further hit 6.6497 in October 2010; the appreciation is 3% in total, which is the highest center point of the past five years. As a result of this announcement, the RMB may appreciate or depreciate more significantly in value against the U.S. dollar or other foreign currencies in the long term, depending on the market supply and demand with reference to a basket of currencies.

To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the effectiveness of these hedges may be limited and we may not be able to successfully hedge our exposure. Accordingly, we may incur economic losses in the future due to foreign exchange rate fluctuations, which could have a negative impact on our financial condition and results of operations.

The following table sets forth a summary of our foreign currency sensitive financial instruments as of September 30, 2010, which consisted of cash and cash equivalents, investment in debt securities, account receivables, prepaid and other current assets, and current liabilities. The maturity of those financial instruments was less than one year and their book value approximated fair value.

 

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     Denominated in (in thousands)      Total  
   US$      RMB      HK$     

Cash and cash equivalents

   $ 161,389       $ 372,057       $ 1,216       $ 534,662   

Investment in debt securities

     0         74,615         0         74,615   

Account Receivables

     1,553         68,525         24         70,102   

Prepaid and other current assets

     4,592         15,270         4         19,866   

Current liabilities