NetEase Inc (NTES) 2005 Q4 法說會逐字稿

Good day everyone and welcome to the NetEase fourth-quarter and fiscal year 2005 earnings conference call. As a reminder, today's call is being recorded. For opening remarks and introductions I would like to turn the call over to Ms. Brandi Piacente. Please go ahead, ma'am.

Thank you operator. Today you will first hear from Mr. William Ding, Chief Executive Officer who will discuss some of the highlights of the quarter and for the full year 2005. Next will be Mr. Michael Tong, Chief Operating Officer, who will review our Online Game business; and finally, Mr. Denny Lee, Chief Financial Officer, will review the financials.

Before we continue, please note that the discussion today will contain forward-looking statements relating to performance of the Company and are intended to qualify for the Safe Harbor from liability as established by the U.S. Private Securities Litigation Reform Act. Such statements are not guarantees of future performance and are subject to certain risks, uncertainties, assumptions and other factors. Some of these risks are beyond the Company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion. Risks related to the fluctuations in the value of the Renminbi with respect to other currencies could also adversely affect the Company's business and financial results. The company's does not undertake any obligation to update this forward-looking information expressed except as required by law.

As the reminder this conference is being recorded. In addition, a webcast of this conference call will be available on the NetEase corporate website at corp.NetEase.com. I will now turn the conference call over to Mr. William Ding, Chief Executive Officer of NetEase.

Thank you, Brandi. Thank you for joining us. I'm very pleased to be here today to review the earning of the fourth-quarter and the fiscal 2005 performance. 2005 was another strong year for NetEase with an impressive growth in our Online Game and advertising business. Total gross revenues for full year increased 76.8% and the net profit was 111.1% from 2004. NetEase (indiscernible) as a position in China as a number one Online Game operator and one of the most popular websites with 786 million patrons in December of 2005.

Total growth revenues for the fourth quarter increased 5.3% over the prior quarter and [75.3]% over the fourth quarter 2004. Net profit was for the quarter grew 7% over the third quarter of 2005 and 112.6% over the corresponding period in 2004.

Touching upon each segment, our Online Game business continues to outpace the industry in 2005 with the total growth revenue growing more than 119.3% from 2004 compared to industry growth of [62.6]% according to the IDC. Fourth-quarter Online Game revenues were better than our guidance provided for the fourth quarter and grew 7.6% over the further quarter and 92.5% over the same period a year earlier.

China's Online Game market is the largest in the world. There were (indiscernible) 26 million users in 2005 compared to 20 million in 2004 with Online Game sales in China expected to grow by approximately [25]% annually to reach $2.1 in 2010 according to IDC. Moreover the growth margin of our Online Game business (indiscernible) make it the most profitable part of our business.

Our success has been driven largely by our two leading in-house development games, Westward Journey Online II and Fantasy Westward Journey. Once again, experience the new (indiscernible) in the fourth-quarter to over 1 million (indiscernible) users recording in late December. The power of the NetEase brand encourages a marked image of our users and our innovative products and the service offered on our portal has been the main centric for our user's business. This is the advantage we have over our competitors.

Turning now to our new game (indiscernible). Currently both our 2.5D and 3-D games are in various stage of beta testing. Da Tang, or our 2.5D game is under external close data and to change our 3-D game is under internal close data. We expect that the open data launch of Da Tang and the chance to be in the quarter of 2006, we continue to focus on efforts on [building] performance of our expanding our Online Game while continuing to invest and develop our next generation 2.5D and 3-D game (indiscernible).

Touching on our advertising business, fourth-quarter revenue earned 5.9% versus the third quarter but still manage to continue in spite of our company (indiscernible). Lastly, NetEase demands the largest e-mail provider in and China. NetEase continues to (indiscernible) enhancing revenue by a combination of website content enhancement and aggressive focus on our (indiscernible) the network our innovation marketed channels and sales efforts.

Let me turn now to Michael Tong who will provide an overview of our Online Game business for the quarter.

Thank you, William. Hello everyone. I will now provide a more detailed overview of our online gaming business for the quarter. Overall we were satisfied with our progress in our Online Game business in the fourth-quarter. Total revenues for this segment grew 7.6% quarter over quarter and 119.3% year-over-year driven by the continued success of Fantasy Westward Journey and Westward Journey Online II.

Our leading MMORPG game, Fantasy Westward Journey continued to be the most popular game in China and Westward Journey Online II was able to hold onto its number three position in terms of peak concurrent number of players. Fantasy Westward Journey grew to over 1 million peak concurrent users in late December, the games at highest PCU since its release in 2004 and the highest number of peak concurrent users in the entire MMORPG markets angina. We are pleased to see Fantasy Westward Journey grew by 8.2% in terms of revenue during the quarter although our expectation was higher.

On the contrary, Westward Journey Online II has achieved 5.8% growth during the quarter reversing the previous increased trend and has once again proven NetEase's capabilities in expanding the lifecycle of games we operate.

In view of the current market's popularity and success of our two in-house developed games, we continue to focus of more resources on developing better and more comprehensive expansion pack, new content for Westward Journey II and Fantasy Westward Journey to take full advantage of the growing strength and nationwide popularity of these games. The success of our in-house developed 2-D game is not only evidenced by the continued help of China's MMORPG markets. So the true testament of the steel of our team strength to the company by producing games that drive customer loyalty and sentiment.

In addition to driving solid growth with our existing MMORPG game, we continue to invest heavily in our game pipeline which includes Da Tang, our 2.5D game and Tian Xia our 3-D game. Although there has been further delay in launching the open data of Da Tang, our 25D game, we believe such a delay will be rewarded by the market when NetEase releases this highly required game. We are at the moment implementing changes based on the comments we received from the daily users. As for Tian Xia, we continue to target the open data for the games to be released in second quarter of 2006 and we continue to have high confidence on the success of this game.

All in all, 2005 was an exciting year with NetEase experiencing high growth, execution, investments and demonstrating its dominance in the Online Game market in China. We were able to maintain a leading position amongst our competitors and once again outpaced the Online Game market. This demonstrates the strength of our business model, execution on all fronts by our top management and management team, a top tier employee base, a strong position from the top down and dedication to help shape the Online Game markets and drive the high quality of MMORPG games throughout all of China.

Let me now turn the call over to Denny Lee who will go into a little more detail on the numbers for the last quarter and the full year of '05.

Thank you, Michael. I will go through some of the key highlights for the quarter and for the year 2005. All the numbers are in U.S. dollars. Fourth-quarter total gross revenues increased 5.3% quarter-over-quarter and 75.3% year-over-year to $60.4 million. Total gross revenues for the full year increased 76.8% to $210 million. Fourth-quarter gross revenue in our Online Game business were better than the Company's guidance and increased 7.6% sequentially and 92.5% year-on-year to $49.7 million.

Full year 2005 gross revenue increased 119.3% to $170.9 million and was a main driver of our top-line growth. Advertising service revenues were also better than the Company's guidance. Gross revenue decreased by 5.9% quarter-on-quarter and increased 54.6% year-on-year to $8.6 million in the fourth quarter. For the full year, advertising revenue increased 41% to $29.9 million. Wireless value-added services and other revenues increased to 4.4% quarter-on-quarter and decreased at 30.9% year-on-year to $2.1 million in the fourth quarter.

For the full year, wireless value-added service and other revenue decreased at 53.4% to $9.1 million. We believe the wireless value-added service market is subject to ongoing restructuring of the industry and margin erosion due to increased local competition.

Our gross margins for Online Game business remained relatively stable at 89.4% for the fourth quarter compared to 89.7% in the prior quarter. Gross margins in our online advertising services business declined to 62.9% in the fourth quarter mainly due to the seasonal decline in revenue while quarters remained relatively stable. Gross margins for wireless value-added services and other business decreased to -1.3% in the fourth quarter from 11.3% gross profit in the prior quarter mainly due to higher costs associated with the Company's services that are free of charge, such as free e-mail services which are included in this business segment.

Total operating expenses for the quarter were $11.8 million representing a 0.2% sequential increase and a 23.2% year-on-year increase from the corresponding period a year ago. The slight quarter-on-quarter increase in total operating expenses was mainly attributed to special year-end bonuses granted to the Company's Online Game development team in recognition of the success of such team during the past year which were substantially offset by lower marketing expenses.

The lower marketing expenses in the fourth quarter resulted from the discontinuation of certain outdoor advertising and overall reduction in the number of Company-sponsored marketing events. For the full year, total operating expenses were $44.6 million representing a 32.3% increase over the prior year's $32 million mainly due to the increase in R&D costs as a result of the increase in headcount for our Online Game team as well as the $2.5 million dollars one-time licensing fee we paid here in the first quarter in 2005 for the Online Game 3-D engine. Apart from that, G&A expenses also increased as a result of the Sarbanes-Oxley compliance work undertaken in 2005.

Our effective tax rate increased slightly from 9.3% in the first quarter to 10.5% in the fourth quarter due to fact that more revenues are being earned by one of the Company's subsidiaries that has a higher applicable income tax rate during the fourth quarter. We expect our effective tax rate for the first quarter in 2006 increased to around 12% mainly due to the [back-up] accounting for share base compensation expenses under the new U.S. accounting rules.

We reported another solid quarter of net profits which reached the $34.3 million representing a 7% sequential increased and 112% year-on-year increase. The Company reported diluted EPS per ADS of US$0.96 in the fourth quarter compared to US$0.89 cents for the [third] quarter. For the full year, net profits totaled $115 million, a 111.1% increase over prior year. The Company reported diluted EPS per ADS of $3.27 for the full year 2005.

As of December 31st, 2005, our combined total and held for maturity investments were US$418.5 million. As we reported, a positive operating cash flow of $27.3 million and $136.9 million for the fourth quarter and for the full year 2005 respectively.

Now I'd like to read you our financial guidance for the first quarter of 2006. Please note that the following outlook statements are based on current expectations. These statements are forward-looking and actual results may differ materially.

We expect the total gross revenues of the Company in the first quarter in 2006 to be between US$63.3 million and US$64.7 million; with Online Game services revenue to increase by 8% to 10% quarter-over-quarter; and advertising service revenue to decreased by 8% to 10% quarter-over-quarter; and wireless value-added services and office revenue to be flat or decrease of 10% quarter-over-quarter.

Net profit during the first quarter is expected to be US$33.1 million and US$34.2 million. This estimate includes the effects of share based compensation expenses of approximately US$3.6 million which the Company is expensing for the first time in 2006 under new U.S. accounting rules. Please note that such share based compensation expenses are non-cash expenses and will not result in any cash payment by the Company. Also we cautioned that we cannot predict the future exchange rate of Renminbi versus other currencies, and therefore cannot accurately estimate the effect of any changes in exchange rates on our financial results. Accordingly, our guidance assumes no change in exchange rate in the first quarter in 2006 and have adopted the same exchange rate as of 31st of December, 2005 of US$1.00 to RMB8.0702. Our actual results could differ however from our guidance as a result of fluctuation in the RMB exchange rate.

We will now be happy to take your answer. Operator, please open the floor for Q&A.

(OPERATOR INSTRUCTIONS) Safa Rashtchy with Piper Jaffray.

Can year me? Congratulations on a great quarter. My question has to do with the competitive landscape. You mentioned that the games maintained their position basically both Fantasy and Westward Journey II. Last quarter you talked about the competition impacting the growth rates. Within that context, could you give us a sense of how do you see the competition from at least two angles? One, just competitive products from other companies as well as the pricing issue especially in light of what [Chandler] has instituted with [3-D] play. And how do you think it has any impact in the quarter as well as what is your outlook for '06 in particular with the new games? Will you be following a similar pricing pattern or not? Thanks. I'm sorry for a complex question.

This is Michael Tong. We have explained in the last quarter that the competitive landscape during the last quarter was a bit more serious than we thought especially with the launching of Future Fantasy from Tencent. And just the effect has seemingly to be a little bit fading during the quarter as we see that our competitors' products continue to become a commercial product rather than a free product. We also see some of the changes during the quarter. But for '06, we believe that the competitive landscape continues to be just as competitive. We continue to expect new games coming out from different competitors, like maybe Tencent or other places. Of course obviously we are very confident with our new games and also very confident with our team of operations and also existing games. Did we answer your question?

Yes. Thank you.

Wallace Cheung with Credit Suisse.

William, Denny and Michael for a good quarter, congratulations. My one question is actually directly to William. May I just ask in Mandarin and then translate to English first? (Mandarin)

My question is actually to William Ding asking his position in the Online Game industry in particular, the growth and any kind of (indiscernible) seeing and any investment plan in casual games? Thank you.

(Mandarin).

Let me try to translate William's answer on Wallace's question. First is that William believes that there is still a lot of opportunity in the Online Game market in the future in China especially in both the casual games and also of course MMORPG. Our advantage in this particular industry is that we have very good quality of research and development; we have also accumulated a lot of experience in terms of the developing our good games. Also, we also have a very good distribution platform for distributing our games and also our phonecards in the China markets.

William's view on the government is that the government is very supportive and open to the industry. NetEase felt we also agree and also very supportive to the entire (indiscernible) system which is targeted toward players who are under age and restricting them to play three hours basically for every session. That is it.

Richard Ji, Morgan Stanley.

Hi. William, Michael, Denny, a very strong quarter. I have one question directly for William. Allow me to ask the question in Chinese. (Chinese)

(Chinese)

In translation. For Da Tang we started our internal closed data in September last year of 2005 and now it is now actually under external closed data. We now have actually around 100,000 accounts in terms of total number of accounts in the external closed data. Since then, since last year in September, we have such different kinds of information from our players for the game and we have been able to see that the playability of the games are not as good as we had expected. This such information from the players we view that game lifecycle might be short when the playability is not as good as what the players think.

So during this period of time, we have been adding different kinds of content into the game including different [mats], changing the characters, different attributes, adding more stories and so on and so forth in order to make sure that the lifecycle of the game will be very long. For example in Westward Journey II our lifecycle of the game is very long and is physically longer in terms of the market.

We are hoping by changing all of these attributes we can extend the lifecycle when the game is being launched and we are looking forward to and open data launch in the second quarter of '06 and our games are a little bit different because the open data always changes we believe our open data will be comparatively shorter than other people's -- other operator's games on open data. Thank you.

Frank Shi with CLSA.

Good morning, guys. Can you talk about the growth prospect for your online advertising business? (Chinese)

Well the advertising growth in '06, we think that we will be able to keep the market the overall markets because for one our advertising business is actually a little bit smaller than our competitor's such as (indiscernible) and for the past of '05 we have been catching up in the market. To give you some figures we have in the branded advertising, we believe our market share has grown by around from 12% to around 14% because we haven't got all the numbers from the (indiscernible) or Tencent. But definitely a growth from 12% to 14% in 2005. We believe the growth of our Company will continue to pick up a bit more market share in the overall branded advertising markets.

That is for the branded advertising market. For the search market, I think we have still a very small player right now and we have yet to see what -- how we can try to perhaps get a bit more market share.

Dick Wei, JPMorgan.

Good morning, William, Michael and Denny. I have a question on online search. I wonder what is the plan for NetEase in terms of search engine development and the plans in the future? Thank you.

Dick, we now are for the search business obviously we are now partnering with Google. The partnership with Google has been with us for more than 1.5 years right now. We will continue to work with Google going forward. And of course you know we will continue to seek different options on the search when the time is right.

Lu Sun, Lehman Brothers.

Hi, William, Denny and Michael. I have a question on your longer-term strategy with Internet entertainment. I think William actually mentioned in one of the industry conference that NetEase is also interested in exploring the home entertainment market. Can you elaborate on that? (Chinese)

(Chinese)

I translate on this. For the home entertainment there has been some reports that will impact in the industry conference that we have some plans for the home entertainment and this home entertainment, a lot of people have implied that a box or something but the truth is that the reporter has basically give out kind of misleading reports. The truth is that we had no plans, no clear plans to do any kind of home entertainment box or something. But we will continue to look at and be very serious in looking at the possibility of the home entertainment. But there is no definitive plan at all.

Okay, William and Michael. Can I ask a follow-on question? It seems like your casual game business is not as strong as a some of your competitors, let's say Tencent or even [Fina]. Are there any solid plans to really present this business and really make it like the top casual game platform in China? (Chinese)

(Chinese)

We believe that the casual game market has great potential in China. And we are actually also advertising quite an amount of resources in developing this market. In more specific terms, we are developing a second generation of the casual game engine perhaps we are developing right now. And with these engines, we believe that we will be able to develop better and casual game in a much faster way than we have been and also compared to the market. We are still very positive that we will be able to do very well in the casual game market just like the way we have done it in the MMORPG markets. Thank you.

William Bean with Deutsche Bank.

A couple of questions. First off just wondering whether you can give us an update on how your promoter network is doing especially in the second and third tier cities? Do you have an update on whether there is any changes there, whether you are seeing any competition from other players to your promoters?

The game promoter I think you are talking about is kind of friends recommending friends system that we have been using for the past two or three years, right?

Yes, any changes there? Yes.

Yes, actually during the past two or three years there has been a lot of people trying to kind of copy or get inside from this system and develop similar systems. So far as far as we understand not -- none of our competitors has been able to develop such a programs in the way that we have developed it. Mainly because I think we have managed the programs very well. We have put a lot of resources in defining the policies with game promoters and we have also -- it is a system that we have been running for more than three years. This system has been very well developed and the quality, how we managed the promoters, how we educate them, teaching them to promote our games and all these things, I think that is actually too difficult for our competitors to catch up.

Thanks. Just could you give us a sense of how we should think about your expenses over the course of '06 as you launch your games?

You mean marketing expenses?

Yes. Your marketing and related expenses. Market as well if there's going to be any change there?

Actually the launch of the games of course in terms of the marketing expense there will be a small increase in terms of the marketing expense but this more increase is actually a little bit immaterial to the overall Company picture. In the history of NetEase, we have never been -- we have never put like too much marketing expense on the launch of games as you can see in the launch of Westward Journey or Fantasy Westward Journey. This will continue to be the same. The fact is that as we are portal, actually a lot of the marketing and advertising can be done through our portal. All the traffic that we have and then specifically no cost to us.

Antonio Tanbunan with Bear Stearns.

Congratulations on a great quarter. Quick question on follow-up to a couple of questions that were asked earlier. On the casual game platform, I know you mentioned your R&D development. When do you actually expect to see some kind of a meaningful revenue contribution? Is it going to be sometime in late '06 or is it something that's going to happen in '07?

I think it's just too early to answer in any meaningful way right now. We just cannot answer on this.

Not a problem. Also the follow-up on the cost question. 2.5 and 3-D games you've mentioned before generally are a lot more expensive to operate, so therefore the impact on gross margin, are we looking at how big of a margin change or decrease in gross margin would you expect with something like that?

Tony, this is Denny Lee and let me take a question. On the Next Generation games, the cost of running the game is a little bit higher than the traditional 2-D game. It's under the 2.5D and 3-D games, we expect there will be a 1% to 2% higher margin. The cost of running of the 3-D game is in fact 1% to 2% higher than the normal traditional 2-D game. So I will expect when the revenue contribution from the Next Generation game is more meaningful in our Company then there will be a bigger margin impact. I mean for 2006 because the majority of our revenue is contributing or coming from the exiting two titles which (indiscernible), there will be some scalability. I think 2006 the margin will not be impacted by much.

Okay, thanks. My last question is in light of your plans to build out your R&D, a lot of the Korean and American companies especially in the most recent quarter in their calls have been talking about building out -- using China either as a creative development base or to as a back-end programming site. Do you see, foresee any kind of problems on the recruiting side especially since you're the top developer? Is there going to be any pressure to find talent? And if it is, is there going to be any pricing pressure on the talent like we saw back in the original .com days?

Recruitment has always been a very important area that we have been focusing on. We have already three years of recruitment kind of country-wide to different type of universities and colleges to recruit our Online Game staff. We have imposed our very good training program for all these guys and we have quite a bit of experience in recruiting people and training them and to become a very important -- be able to develop our games.

So I think with our presence in the Online Game industry being the number one in terms of MMORPG and the Company itself I think, we have been very competitive in being able to recruit very good people into our Company. I think competition does not really come from the like of what you said is the foreign competitors from like the [EA] or something. But partly it could be because of Google or like Microsoft or something who are expanding their presence in China. We are very mindful of that and we will continue to work very hard in recruiting the best people for the Company.

With Susquehanna Financial Group, we have Ming Zhao.

Good morning gentlemen. Just have a question. Could you give us some color on the lifecycle of the existing two games? I remember Michael you said that the Westward Journey Online II will probably peak in the near term and just wanted to have update of your thoughts about Fantasy and Westward Journey Online II. When would you perceive there will be a peak? And then I have a follow-up.

Let me explain a little bit. From the experience that we have of course as I mentioned, it depends a lot on the content we are able to put into the game. And that if it is a good content there we will be able to extend the lifecycle a bit further. And from past experience we have for example like Westward Journey II Online, the growth of the fourth quarter has picked up again compared with third quarter. Also just one quarter ago, I think everybody said we got Journey II Online is going in a kind of a downtrend. I think a lot depends on the content of the games and so far we have been able to put up good content and be able to expand the lifecycle. Exactly when it just difficult to say and we cannot guarantee anything.

I think we have time to take one more question.

Tian Hou with C.E. Underberg.

I have a question.

Ma'am, this is the operator, were having some trouble hearing you.

I'm here, okay. First question you have a lot of cash. Where do you plan to use it? (Chinese)

(Chinese)

Okay. (Chinese) Open data -- the schedule how you commercial launch the schedule. I don't think I get it correctly. (Chinese)

(Chinese)

Okay.

(Chinese)

Let me do kind of the explanation and translation. We just cannot answer -- the question was I think explain in English. The question was when are we going to have the commercial launch for Da Tang and the answer is that we just won't be able to answer exactly when it's going to have the commercial launch. We will answer in a more indirect way is that from our previous experience that Fantasy Westward Journey, we have spent about one months time in the open data and also for Westward Journey Online II, which was previous product we spent around three months in open data. And the reason that we have shorter open data in Fantasy Westward Journey is because the game itself has been very well refined when we started the open data and it is a very short open data.

Okay, I have a follow-on question. (Chinese)

(Chinese)

The question was are we going to have any problems if we have such a close time in launching open data for the two times together? And the answer is that because we have currently different demographics for the two games, for example Da Tang it is targeted toward users who have kind of a lower hardware requirement. For Tian Xia, the hardware equipment is much higher. And also in terms of that will target in different geographically and also different profiles and users and players. We believe that even that is a very close period of time in launching open data for the both games. Because of different profiles we don't expect to have a lot of problems.

For example, for Fantasy Westward Journey we also thought about that it might effect the user growth of Westward Journey II Online when we launch the game but also because we are targeting a different profiles of users, the impact from Fantasy Westward Journey was very immaterial. We believe there shouldn't be any problem in launching the open data for the two games at the very close time.

Okay everyone. Again thank you for joining us today. Please feel free to contact us if you have further questions. Have a good day.

Once again everyone this will conclude this NetEase fourth-quarter fiscal year 2005 earnings conference call. Thank you all for joining us today.