NetEase Inc (NTES) 2006 Q4 法說會逐字稿

Good day, everyone, and welcome to the NetEase fourth quarter and full year end 2006 conference call. Today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to Miss Brandi Piacente. Please go ahead, ma'am.

Thank you, operator. Today, you will first hear from Mr. William Ding, Chief Executive Officer, and Mr. Michael Tong, Co-chief Operating Officer, who will discuss some of the financial and operational highlights of the fourth quarter and fiscal year ended December 31, 2006. 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 future 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 those 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. A general discussion of the risk factors that could affect NetEase's business and financial results is included in certain filings of the Company with the Securities and Exchange Commission, including its annual report on Form 20-F. The Company does not undertake any obligation to update this forward-looking information except as required by law.

As a reminder, this conference is being recorded. In addition, a webcast replay 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 Michael Tong, Co-chief Operating Officer, who will read the prepared remarks on behalf of Mr. William Ding. Michael?

Thank you for joining us today. I will begin today with recent highlights from each of our service segments and an update on key business developments. Then Denny Lee will provide details on our financial results for the fourth quarter and fiscal year '06, followed by Q&A.

Total revenues for the fourth quarter were $69.2 million, a decrease from $72.4 million for the third quarter of 2006, and an increase from $60.4 million for the fourth quarter of 2005. For the year ended December 31, 2006, total revenues grew to $284.1 million. Online game revenues were $57.9 million for the fourth quarter of 2006, down from $59.2 million for the third quarter of 2006 and up from $49.7 million for the fourth quarter of '05. For the year ended December 31, '06, online game revenues totaled $237.8 million, an increase from $170.9 million in fiscal '05, primarily attributable to the net growth in the popularity of Fantasy Westward Journey for the year.

We made solid progress with Fantasy Westward Journey during the fourth quarter of '06. This game achieved record PCU metrics of approximately 1.3 million for the fourth quarter, and ACU metrics of 444,000. This game continues to dominate the MMORPG titles in China. Westward Journey II Online also achieved record PCU for the fourth quarter, reaching approximately 603,000 and ACU metrics of 173,000.

Internal closed beta testing of the upgraded version of Westward Journey Online II, called Westward Journey Online III, is on schedule to begin in the second quarter of 2007. And open beta testing will follow in the third quarter. We are planning the commercial launch for Westward Journey III this year and are developing a plan to upgrade the existing players of Westward Journey II to the new game platform.

Turning to Tianxia II, the Phase II unlimited open beta test will be launched this week on March 1. As we announced in December, we initiated our testing to a limited audience of approximately 100,000 accounts during the Phase I open beta period. By doing so, we expect to conclude the Phase II open beta period more efficiently. So far, the testing process for Tianxia II has proceeded smoothly and we expect the commercial launch to occur in March before the end of the first quarter.

We initiated Tianxia's commercial marketing program in early February in anticipation of its commercial launch. For our Tianxia II time-to-market strategy, a dual phase open beta test was the best way to achieve a comprehensive testing framework that would enhance our ability to deliver a flawless best-of-breed game. And because of this, we are confident in the market potential and player appeal of this next-generation online 3-D game.

Our latest released game, Datang, continued to deliver a modest contribution in its second full quarter since commercialization. During the fourth quarter, we continued to make modifications to enhance the game players' users' experience. Overall, we are proud to say that NetEase maintains its leadership position in MMORPG market share in China.

Turning to our Advertising Services segment, revenues from Advertising Services were $9.2 million for the fourth quarter of '06, a decrease of $10.5 million for the third quarter of '06 and an increase from $8.6 million for the fourth quarter of '05. The quarter-over-quarter decline in advertising revenue was expected due to seasonally slower activity during the fourth quarter. For the full year '06, advertising revenues grew to 36.3 -- $36.6 million, attributable in part to China's robust and high-growth online advertising markets. Our solid annual growth in advertising revenues also reflects the value that our advertisers place in the new portal products, contents, functionality, community services, and collaborative relationships that we invested during the year.

Total average daily page views for the month of December were more than 710 million, up from 660 million in December '06. Our page view metrics clearly continue to rank NetEase as one of the most popular destinations in China, according to a recent China Internet survey report. This leadership position is one that we are continually reinforcing through premium content and service development and innovations.

During the fourth quarter, I am very pleased to report that we advanced towards the online search market with the beta test launch of our brand new proprietary search engine. Our robust functionality is built on our strong intellectual capital, and our entry into this market is a natural progression for NetEase. We have a huge built-in audience for search with our online communities within our portals, e-mail users, and a growing blog community. We expect the official market launch of our search product to occur in the second quarter, and we look forward to updating you on this major milestone in the near future.

With that, I would like to turn the call over to Denny for his review of our financial results.

Thank you, Michael. I would now provide an overview of our financial highlights using numbers and percentage based on U.S. dollars. I will begin with a review of the fourth quarter, followed by a summary of fiscal year 2006 results. In order not to repeat what happened just explained by Michael on the revenue side, I will focus on explaining margins and expenses fluctuation along with net profits.

Beginning with the fourth quarter, gross revenue was $58.5 million compared to $56.7 million in the preceding quarter, and $47.9 million in the same period in 2005. The Company's overall gross margin was 82.4% for the fourth quarter compared to 81.7% for the preceding quarter, and 82.6% for the same period last year. The increase was primarily attributable to the increase in the gross margin for online games.

Gross margin for the online game business for the fourth quarter of '06 was 90.3% compared to 89.4% for the preceding quarter, and 89.4% for the fourth quarter of '05. The increase was primarily due to our business tax refund of $4.5 million, which was approved by the relevant tax authority in the fourth quarter of '06. Gross margin for advertising business was 50.5% for the fourth quarter of '06 compared to 56.1% for the preceding quarter, and to 62.9% for the fourth quarter of '05. The quarter-over-quarter decrease was primarily due to seasonal decline in Advertising Services revenue in the fourth quarter, while costs remained relatively stable. The year-over-year decrease was primarily due to the increase in salaries and other benefits paid to content editors and the increase of costs associated with the online advertising business, so as to enhance the content and attractiveness of NetEase's website.

The gross margin for the wireless value-added services and other business for the fourth quarter of '06 was -18.9% compared to gross margin of 3.4% for the preceding quarter, and a gross margin of -1.3% for the fourth quarter of '05. The decline in gross margin was primarily due to the full quarter impact of the implementation of a new requirement that customer provide double confirmations to order SMS monthly subscriptions, and the further strengthening of billing policy and procedures of certain provincial mobile network operators. The year-over-year decrease was primarily due to increased server depreciation costs associated with our free e-mail services, and redundancy costs paid to staff in rationalizing the wireless value-added services.

Total operating expenses for the fourth quarter of '06 was $15.9 million compared with $16.6 million for the preceding quarter, and $11.8 million for the same quarter last year. The decrease in operating expenses in comparison to the preceding quarter was primarily due to lower marketing expenses resulting from the completion of our substantial marketing campaign launched in the third quarter. The decrease was partially offset by increased office rentals and a higher provision for doubtful debts. The year-over-year increase in total operating expenses for the fourth quarter was primarily due to a one-time write-off of $1.4 million in software costs for our licensed online 3-D game Fly for Fun, and increased research and development expenses associated with increased staffing for enhancing our existing products and development of new products.

Net profit for the fourth quarter totaled $41 million compared to third quarter net profit of $39.8 million, and $34.3 million for the fourth quarter of '05. Our basic diluted earnings per share ADS were 0.32, $0.32 and $0.30 for the fourth quarter of '06, respectively. This includes the impact of approximately $3 million, or $0.02 U.S. per ADS, in non-cash share-based compensation costs. In comparison, basic and diluted earnings per ADS were $0.31 and $0.29 for the third quarter of '06 and $0.27 and $0.25 for the fourth quarter of '05, respectively.

Now turning to our results for the year ended December 31, '06, gross margin was 82.4% in 2006, down slightly from 82.9% in fiscal 2005. Net profit for fiscal 2006 was $159.2 million, or diluted earnings per ADS of $1.14. This includes share-based compensation cost of approximately $13 million. Net profit for fiscal 2005 was $115.5 million, or diluted earning per ADS of $0.82. No share-based compensation cost was recorded in 2005.

As of December 31, '06, our total cash and time deposit balances was $504.6 million, an increase from $478.7 million at September 30 of '06, and an increase from $418.5 million at last year end. Cash flow generated from operating activities was approximately $68.1 million, up from $43.6 million for the third quarter of '06, and up from $27.3 million for the fourth quarter of '05.

With regard to our Board-approved share repurchase program of up to $100 million U.S. of the Company's outstanding ADS, as of December 31 of '06, we had effected transactions in the open market, purchasing approximately 3.6 million ADSs for an aggregate purchase amount of approximately [$360.1 billion], including transaction costs. This represents approximately 60% of the total authorized share repurchase amount. The share repurchase program will end on March 4, '07.

As we indicated in our conference call last quarter, in order to allow investors to focus more on long-term value and strategy of our Company, we will not be providing quarterly guidance for 2007. We will be happy to take your questions. Operator, please go ahead.

(OPERATOR INSTRUCTIONS). Richard Ji, Morgan Stanley.

William, Michael, and Daniel, congratulations on a good quarter and I have actually two questions regarding your existing game, Fantasy Westward Journey and Westward Journey II. Regarding Fantasy Westward Journey and when you expect to roll out the new expansion pack to ramp up the user volume. And on Westward Journey II, especially I am curious about your plan to migrate your user base to Westward Journey III. And do you have any concrete plans at this stage? Thank you.

Richard, do you mind to -- when you ask the question, do you mind to just translate into Chinese as well?

(Spoken in Mandarin).

(Spoken in Mandarin).

So, let me put that in English. Fantasy Westward Journey has just released an expansion pack in January. And we are preparing another new expansion pack, but we have not fixed the time yet. And for Westward Journey III is part of an upgrade to Westward Journey II and we would try to -- we will keep the existing users of the Westward Journey II into the new platform.

William, (Spoken in Mandarin).

(Spoken in Mandarin).

Just to summarize is that when all the users will be transferred into Westward Journey III, then we will stop the operation of Westward Journey II. That is the idea.

Lin Shi, Lehman Brothers.

William, Michael, Denny (Spoken in Mandarin).

(Spoken in Mandarin).

Okay. (Spoken in Mandarin).

(Spoken in Mandarin).

Okay. (Spoken in Mandarin).

Why don't I do a very brief summary before we go on to the next one? So the question was why was there growth in the ACU of Fantasy Westward Journey? And the simple answer is that besides the Christmas and the New Year's activities that we have done for the marketing during that time, we have also put a lot of hard work in improving the security control for the players who used to have some stolen accounts, and that makes them difficult to lock into the games, and so. But we have improved on the security systems and so that more and more players come back to play for the games.

And the second question was how do we think about Tianxia and no doubt to -- the answer is that no doubt that competition is very fierce, but as we have prepared the game for a long time. And also that we have developed a game with -- for the taste of the Chinese users and culture, and we are still very confident about the game. Next question.

William Bean, Deutsche Bank.

Denny, William, Michael, (Spoken in Mandarin).

(Spoken in Mandarin).

Okay. I will just do it in English. It's probably easier. Could you just give us a sense of Tianxia II, your marketing plan, as well as your marketing plan for Westward Journey Online III. And the second question is what is your goal in terms of transfer of Westward Journey Online II users to Westward Journey Online III in terms of percentage? Thanks.

(Spoken in Mandarin).

Hello?

Okay.

Why don't I translate. The marketing -- the question was the marketing budget for Tianxia II and the answer is that we have a plan. It's in progress, but there is not much to disclose right now, actually.

(Spoken in Mandarin). How many users do you hope to get to move from Westward Journey Online II to Westward Journey Online III?

(Spoken in Mandarin).

We don't have any answers on this question, actually.

Okay. Thank you.

Ming Zhao, Susquehanna International Group.

Hi. (Spoken in Mandarin). Thank you.

(Spoken in Mandarin).

(Spoken in Mandarin).

(Spoken in Mandarin).

Okay. And my second question is for Denny. Can you break down the revenue from Fantasy Westward Journey Online, Westward Journey Online II, and Datang in the fourth quarter?

Yes. The revenue breakdown for the online game business was roughly for Westward Journey Online II the revenue in the fourth quarter was around 28%, whereas the Fantasy Westward Journey was around 70%, and the rest is from Datang.

[Alicia Yap], Bear Stearns.

Good morning. William, Michael, and Denny. I will try to ask my question in Mandarin first to follow the trend and followed by English. (Spoken in Mandarin). This is my first question. For the Westward Journey III, will you guys change your business model? Will that continue as a subscription base or will you change to be an item base? And I have one follow-up.

(Spoken in Mandarin).

Okay. (Spoken in Mandarin).

(Spoken in Mandarin).

(Spoken in Mandarin). My second question is on the R&D costs. Are you seeing any rise per head cost in the games R&D as the industry is becoming more competitive, especially we are seeing in Korea and U.S.? Thank you.

(Spoken in Mandarin).

Okay. Let me summarize this section. This is an excellent question and is Westward Journey III going to be a free game or going to be a paid games? And the simple answer is that it is going to be a subscription-based paid games, rather than an item-based games. And the other question was how do we look at the increase in the R&D cost, especially given the competition for talents in the markets right now. (indiscernible) we believe that salary increase is not just one of the ways to keep our talents. In fact, we have been doing a lot in providing business benefits and so on for our staff. And also, we have been hiring a lot of new staff as well as for our reserve for talent. We can go on to the next question.

Anthony Gikas, Piper Jaffray.

A couple of questions on the new search engine. Could you quantify the potential revenue impact during the second half of this fiscal year related to advertising through the search engine? When will those revenues also become material? Second part of the question, could you characterize your expenses that you have incurred in developing the new search engine and what will that be going forward? And then I have a follow-up question.

Anthony, this is Denny Lee. Let me try to answer your questions. First of all, I think the search engine is now under internal beta, and we will start our open beta very soon. But on the revenue generation potential, this is still early, because we have our plan, we have milestones to achieve. First of all, we want to make our game technically sound and also before we try to think about the monetization. But definitely we will try to give a very good product, good quality product to the users and regarding the --but we are overall optimistic on the search overall market growth in China. And your second question is regarding the expenditures incurred, and for your information, all the R&D costs in relation to the search engine has already been recorded or reported in the financial statement.

Okay. And when will the revenues -- I mean, should we be expecting some meaningful or measurable revenues from the search engine later this year? And then my last question would be could you just address your plans for the use of excess cash? Do you have plans to complete the repurchase program that is in place today?

Regarding the revenue, we still -- it really depends on the result of the open beta, which will be commenced very soon, and we cannot comment right now. On the use of the surplus cash, and as you know, that we have in the past, in 2006, started to execute two repurchase program. The first one was around $50 million U.S. and it was completed in the middle of the year. And the second one was double the size of the first one, which was around $100 million, and it will end soon. So far, we have executed around 60% of the authorized top limit and we will update the investor in our next conference call on the remaining potential purchase.

Chang Qiu, Forun Technologies.

Good morning. Denny, I guess maybe a question for you. There is some talk regarding potential tax change. I don't know whether or how you see this. If there is a tax code change, how would -- what is the impact to companies like NetEase?

Yes, I think you are referring to the potential unification of the tax rates for foreign company and domestic companies. I think the background is that local companies are mostly paying around 30% plus income tax in China, whereas the foreign companies, because they have the special tax exemption, they are either paying 50% of the domestic companies tax rate. So if there is going to be a unification, then people estimate that the tax rate for -- the unified tax rate will be around 25%, but this is well above our effective tax rate right now, which is around 10% or so.

But I also understand that going forward, the PRC government will continue to give preferential tax treatment for those special industries that the government is encouraging, for example high-tech, for example software companies, and advanced technology companies, etc. So, NetEase has always been enjoying those benefits of special industry which is encouraged by the government. And I foresee that going forward, we will continue to enjoy such preferential tax treatment. So actually, I don't expect to see there will be any material negative impact on the effective tax rate of the group because of the unification of tax rates.

Thank you, Denny.

Tian Hou, Unterberg Towbin.

(Spoken in Mandarin).

This is Denny. Let me first answer your second question regarding the tax rebate. We have clearly indicated in our press release that this is a one-time, nonrecurring event, happening at the end of the year. And we should not expect the similar tax refund to happen going forward.

(Spoken in Mandarin).

Let me try to summarize this. The first question is that we have -- we had some strategic move on the common channels during the quarter of '06. In brief, it's that we have canceled a few channels including travel, health, and also culture channels. And for these channels, we just -- the move and the reason for this move is that we want to focus on the major channels, such as the news, entertainment, and so on, and then for those channels that we have canceled, I would want to add this, that we continue to find partners to collaborate with us on those channels so that we can focus on the major channels ourselves.

And the second question is on the anti-addiction system for the games. And for this it is simply that this system is implemented over all the game operators in China and it is a policy from the government, but it is for the good of the industry. And the third question is --.

The third question was regarding the tax rebate, which is a one-time, nonrecurring event.

Right. Okay.

Paul Keung, CIBC World Markets.

Hello. This is [Claire Ding] for Paul Keung. (Spoken in Mandarin).

(Spoken in Mandarin). And in English it is that the portal right now, basically, includes the e-mail, the blog, and the contents. Besides the -- to improve our contents and the functionality of this product, we continue to integrate all these products together to establish a good community within the portals. And at the same time, we are launching a new product, which is the search that we are in open beta right now. And all of this will continue to drive the growth of the traffic for '07 and also to increase the advertising revenue for '07.

Wendy Huang, Evolution Securities.

Good morning. I have two questions. One is a follow-up on the previous question regarding the effective tax rate. When will your tax holiday expire? I mean according to the current tax policy, do you expect the effective tax rate to remain at 10% level in 2007?

And the second question is that currently you are sitting on quite good cash position. Will you stick to the current in-house development strategy? I mean, where you use this cash to license any games in the future, or will you use this cash to acquire any game studios in China to extend some of your R&D capabilities? (Spoken in Mandarin).

(Spoken in Mandarin).

Let me first of all translate the answer for the second question first. The question was how will you use the cash, the cash reserve. And the answer from William was actually we will consider going forward to acquire companies, R&D company, and also to license games. So we have got to focus on the quality of the game and a reasonable price. And regarding the second question from -- is actually the effective tax rate. At the moment, our effective tax rate was around 10% or a high single digit. And the tax exemption holiday, actually, was actually -- the detail was summarized in our annual report last year, but the effective tax rate -- because different subsidiaries will have different tax holiday cycles. And the effective tax rate of the group we consider going forward will be around the low teens. Okay. The next question?

Jason Brueschke, Citigroup.

Let me start with a follow-up question to the previous one. I asked the same question last quarter about the use of cash and whether you would consider doing any acquisitions or licensing third-party developed games. And I believe you said the answer then was no, that you would not, that you believed in in-house development only. Am I hearing you guys correctly that there is now a change, at least potentially, in the strategic direction that you would if you found the right game at the right price, developed by a third party, say a Korean or U.S. company, that you would now consider licensing such a game?

Well why don't I just answer your question directly. I think for the last quarter, I think firstly there is basically no change in what we think. So I think it is really a matter of how we present it. So in the last quarter, I do remember when you asked us about the use of cash that we said no to the third-party licensing games. And that is no actually means -- it is not a definitively no. What we are saying is of course if there is a good game at the right price, the right terms, the right time, then of course we would also license the third-party game. But our priority continues to be in-house developed games and this is the same right now, where if there is a good game and at the right price, then we would continue to -- it is not impossible for us to license it, but again, our priority is still on the in-house developed games.

Great. Thanks Michael. A couple of other -- maybe a housekeeping question. Did you say during the prepared remarks that you expect to do commercial launch of Tianxia in the first quarter, or did you say the second quarter?

First.

First quarter. Okay. And then maybe one other question on Tianxia, and you may have said this in some of the answers to the previous questions, but if you did, I missed it and I apologize. Did you give us what the PCUs and ACUs were for Tianxia during the Phase I open beta?

(Spoken in Mandarin)

(Spoken in Mandarin)

Sorry, don't have the numbers for the PCU or ACU for this phase of the open beta right now for you to disclose, but once we started the open beta in the first of March, I think we will have some new numbers in the second stage of the open beta. And we will disclose that.

Great. And maybe one last question. There has been a lot of talk, and this is on the advertising business, your portal, of kind of the market in China as elsewhere in the world, as kind of heading more towards rich media and the video. Could you maybe give us an update on what your strategy is with respect to either video on demand or various forms of streaming video, as well as your rich media strategy? Thanks.

(Spoken in Mandarin) Actually, it is very simple. You know, as I have just explained, we have the e-mails, we have the blogs, we have the common channels. The way we think about video is not a separate item, but it is how we can integrate video as part of the content into our current channels and also into our blogs and so on. But we don't have any specific plans right now, but when there is the right time -- I mean, slowly by slowly, we will integrate different kinds of video content into the current product lines. So this is basically our thinking.

Great, guys. And congratulations on a good quarter.

Okay. Thanks.

James Mitchell, Goldman Sachs.

I apologize if the line isn't so great, but can you just run through the massive increase in deferred revenue during the quarter? Was there anything unusual behind that?

The deferred revenue was because -- increased by the end of the year compared to September end. It was because starting from 2007, we have a new policy on pricing, on our [point cost]. So I think before the year end, people already anticipated a change in the policy, but they did not know the detail yet. So they have a lot of the [point cost] at the end of the year.

Great. Excellent. And then maybe a second question. If I look at your advertising growth year-on-year in the fourth quarter versus your competitors, do you feel that you are spending sufficiently on marketing and on product development for the portal and the associated properties? Or do you think that if you spent more aggressively in those areas you would get faster traffic growth and faster revenue growth?

I think your question is that the growth is not as strong as our competitor in the fourth quarter. And the reason it is not really because of the marketing or the investment in the content, it is more -- I think I explained in the previous quarter conference call when we give out guidance is that for one, we have changed our front page, where we are accepting less text link advertisers. I think I mentioned it and that resulted in a bit less advertising in the fourth quarter. And while we have not increased the price on the other advertising space in the front page as yet, so there is kind of a time lag here and I think that is the main reason for the increase -- the small growth over year-on-year in the advertising for the fourth quarter.

And since I am at the back end of the line, where did the minority interest item come from in the fourth quarter?

James, this is Denny. Because we have established a joint venture company, the group, NetEase group accounted for 75% of the interest and there is a 25% minority shareholders. And that joint venture company is set up mainly for the purpose of our new proprietary developer search engine business.

So you have a 25% minority partner in the search engine business, and the $400,000 credit is because that business was losing, whatever, $1.6 million. Okay. Great. That is all my questions.

That is all of the time we have for questions. Miss Piacente, I would like to turn the call back over to you for any further comments or closing remarks.

Thank you, once again, for joining us today. Please feel free to contact us if you have any further questions. Have a good day.

Thank you. Ladies and gentlemen, this does conclude today's NetEase conference call. We would like to thank everyone for their participation, and have a wonderful rest of your day.