NetEase Inc (NTES) 2007 Q1 法說會逐字稿

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the NetEase.com first quarter 2007 financial results conference call. For opening remarks and introductions, I'd like to turn the call over to Ms. Brandi Piacente. Please go ahead, ma'am.

Thank you, operator. 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 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. 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, Chief Executive Officer of NetEase.

Thank you for joining us today. Before I begin the operational review, I would like acknowledge Denny Lee for his more than five years of service to NetEase. Denny Lee, CFO and Director, has submitted his resignation effective June 30 of 2007 for personal reasons, but he will remain a member of the Board of Directors of our Company. We wish to thank Denny for his contributions and dedication during a period of substantial growth and development. We look forward to continuing our relationship with Denny through the Board of Directors and we wish him all the best in his future pursuits.

Onward Choi, our Financial Controller since 2005, has been named Acting Chief Financial Officer. With a background at Ernst & Young and KPMG, Onward is well-prepared to take on his new leadership role. Onward will deliver the first quarter financial review today and participate in the question and answer session at the conclusion of our prepared remarks.

Now, turning to our first quarter operations, total revenues for the first quarter were $71.8m, up from $69.2m for the fourth quarter of 2006 and an increase from $66.1m for the first quarter of 2006. Online game revenues were $62.4m for the first quarter, up from $57.9m for the fourth quarter of 2006 and up from $56.2m for the first quarter of 2006.

Fantasy Westward Journey reported another record for peak concurrent user numbers of approximately 1.5m, up from the 1.3m we reported last quarter. This continued strength in user growth was driven, in part, by major weekend events that we staged during the quarter, along with strong usage as a result of Chinese Valentine's Day holiday. This followed an expansion pack that was released in the beginning of the first quarter.

The game grew by 11% in revenue in the first quarter over the fourth quarter in 2006, and we believe the strong PCU numbers and revenue growth are indicators of the game's ongoing popularity and long lifecycle. We continue to have positive expectations for Fantasy Westward Journey and we're investing in the development of an expansion pack to be launched in the second half of this year.

Westward Journey III, which is the upgraded version of Westward Journey Online II, entered internal closed beta as of last Sunday and is scheduled to enter open beta testing in the second half of 2007. The upgraded version consists of 100% new graphics and several new game-play features and will preserve each gamer's user data.

We are confident in our ability to migrate the existing players to the upgraded version, because the hardware requirements, playing levels and other [standard] features of Westward Journey II will remain the same. Additionally, we have developed an aggressive marketing program in order to attract new users, as well as migrating the existing users from Westward Journey Online II.

With Tianxia II, we are obviously disappointed with our findings during the [limited] beta testing in March. It is not that the hardware requirements are too sophisticated. Rather, the game design and player functionality need to be more conducive to beginner play as well as advanced competitions. We decided to extend our open beta testing during -- until we are satisfied.

Our R&D team is hard at work focusing on two key objectives - first, enhancing group play and player advancement features and second, reducing game complexity for beginners. During this extended development phase, we are reallocating investment to R&D and away from marketing. And we will continue to open beta test until our redesign or redevelopment work is completed and we are satisfied with it.

Turning to our advertising services segment, revenues from advertising services were $7.3m for the first quarter of 2007, a decrease from $9.2m for the fourth quarter of 2006 and $7.7m for the first quarter of 2006. The advertising income as compared to our peers has been lower than our expectations, due to the decrease of advertising spending in industries such as e-commerce. However, revenue growth in other industries has been satisfying, such as automobiles, FMCG and healthcare industry.

Overall, the portal traffic has been healthy in the first quarter, as a result of improved content, such as news, sports, finance channels and other products, including our blog and email services. We believe the [appealing] traffic will help us to continue to grow our advertising business.

Our development of the in-house search engine has been progressing well and we are planning to officially launch it during the second half of 2007, simultaneously with a major marketing campaign. With that, I would like to turn the call over to Onward Choi for his review of our financial results. Onward.

Thank you, Michael. I will now provide an overview of our financial highlights using numbers and percentages based on U.S. dollars. In order not to repeat what has just been explained by Michael on the revenue side, I will focus on explaining margins and expense fluctuations, along with net profits.

First quarter gross profit was $55.7m, compared to $58.5m in the preceding quarter and $52.5m for the same period in 2006. The quarter over quarter decrease in gross profit was primarily due to a one-time business tax refund of $4.5m recorded in the fourth quarter of 2006. The year over year increase in gross profit was mainly due to higher online game services revenue in the first quarter of 2007. The Company's overall gross margin was 80.6% for the first quarter compared to 82.4% for the preceding quarter and 82.7% for the same period last year.

Gross margin for the online game business for the first quarter of 2007 was 89.6%, compared to 90.3 and 90.4% for the fourth and first quarters of 2006 respectively. The quarter over quarter decrease was primarily due to the above-mentioned tax refund. The year over year decrease was primarily due to higher staff-related costs as a result of an increase in headcount and increased server custodial fees and depreciation charges for enhancing our online game development and ongoing business capacity requirements.

Gross margin for the advertising business for the first quarter of 2007 was 35.7%, compared to 50.5 and 51.2% for the fourth and first quarters of 2006 respectively. The quarter over quarter decline in gross margin was primarily due to the seasonal decline in demand for advertising services, while costs remained relatively stable in the first quarter of 2007. The year over year decline in gross margin was due to lower advertising services revenue as a result of increased competition, increased production costs for content enhancement and higher server custodial fees and depreciation charges to support our online advertising business capacity requirements.

Gross loss margin for wireless value-added services and others, for the first quarter of 2007, was 36.1%, compared to gross loss margins of 18.9 and 12% for the fourth and the first quarters of 2006 respectively. The quarter over quarter and the year over year decline in gross margin was mainly due to higher server depreciation costs and server custodial fees to support our expanding free email and photo storage capacities offered to our registered email account holders.

Total operating expenses for the first quarter of 2007 were $15.2m, compared to $15.9 and $14.2m for the fourth and first quarters of 2006 respectively. The quarter over quarter decrease was due to a reversal of provisions for doubtful debts of approximately $1m, as a result of collection of outstanding accounts receivables with respect to the advertising business during the first quarter of 2007, compared to an increase in provisions for doubtful debts of $0.6m made during the fourth quarter of 2006.

This was partially offset by an overall increase in selling and marketing costs of $0.8m. The increase in selling and marketing cost was mainly in relation to the marketing of Tianxia II during the first quarter of 2007. The year over year increase was mainly due to an increase in research and development expenses associated with increased staffing for the enhancement of existing products and for the development of new products.

Net profit for the first quarter of 2007 totaled $39m, compared to $41 and $36.6m for the fourth and first quarters of 2006 respectively. Our basic and diluted earnings per ADS were $0.31 and $0.29 for the first quarter of 2007 respectively. This compares to basic and diluted earnings per ADS of $0.32 and $0.30 and $0.28 and $0.26 for the fourth and first quarters of 2006 respectively.

As of March 31 of 2007, our total cash and time deposit balance was $520.6m, an increase from $504.6m at December 31 of 2006. Cash flow generated from operating activities was approximately $35.9m, compared to $68.1 and $51.4m for the fourth and first quarters of 2006 respectively.

With regard to our share repurchase program, on March 13, our Board authorized a share repurchase program of up to $100m of the Company's outstanding ADS for a period not to exceed three months. As of March 31, 2007, we had effected transactions in open market purchasing approximately $1.1m ADS for an aggregate purchase consideration of approximately $20.8m, including transaction costs.

With respect to the separate share repurchase program of up to $100m authorized by the Board on August 28, 2006, the Company had repurchased approximately 3.6m of issued and outstanding ADS for an aggregate purchase consideration of $60.1m, including transactions costs, as of the ending date of the share repurchase program on February 27 of 2007.

Thank you for your attention and we will now be happy to take your questions. Operator, please go ahead.

[OPERATOR INSTRUCTIONS]. First, we'll hear from Richard Ji of Morgan Stanley.

Hi, William, Michael and Onward. Morning.

Hi.

Good morning.

Hi. I have two questions, first, obviously, starting with your Westward Journey III. And can you just help us understand a little better how will you ensure the stability of your user base during the migration process?

Okay. The stability of the users -- Basically, first of all, we have to explain that Westward Journey III, as we have mentioned in the conference call [just] now, that the game-play will be -- the standard game-play in Westward Journey II will also be in Westward Journey III. And also, at the same time, the user data which is the most important in Westward Journey II will also be migrated into Westward Journey III. So all these experience points that players have played in Westward Journey II, all these things will all be migrated into Westward Journey III and this is a very important value for the users.

But Westward Journey III, we also look at it as a very new game. For example, all the graphics will be 100% new, as compared to Westward Journey II. And the reason for that is especially because there are new game designs, new game-play, that we are designing with these new graphics that can be implemented in this new game, because in Westward Journey II the engine has been old and a lot of things that we want to implement just cannot be implemented. But with the new engine, new graphics, we can do a lot more and be able to retain the existing users and, at the same time, we're trying to attract new users as well.

And in terms of technical complexity, the new game will not increase the [inaudible] the hardware requirements.

Basically, no. The game will continue to be a turn-based game and the hardware requirement will continue to be very low. It is going to be a 2.5D game. It is not going to be a 3D game. So it should be totally fine.

Okay, good. And my second question is regarding your online search and portal strategy. Obviously, we know you have heavy traffic on your [leading] portal. I'm particularly interested in how you're going to [monetize] your portal traffic. Would it be more focused on your online brand advertising strategy? And also -- Can you also help us to understand a little better about the commercialization of your [pay-]search? Thank you.

Sure, of course. Let me talk about the portal, first, and then I will ask William to talk about the search, okay? So for the portal, I think the good news for us is we have -- the content channels have been doing pretty well for the last quarter or two. We have been seeing very strong growth just looking at the content channels. For example, the news, the finance, entertainment, sports and so on. That is -- I think it's a result that the market continued seeing that the improved content. And then we are really being able to market it right now, and that's also resulted in better advertising revenue in those products.

At the same time, our growth in the emails and the blogs has been doing well, although I have to explain that the advertising for those products, we are working on it to see how we can better monetize emails and, for example, blogs. And, for example, blogs, basically, the advertising budget that we have been doing has been very, very low and so is the industry as well, but we believe there are ways that we can monetize it better. So I think on the portal, overall, it's doing fine, but I will let William --

[Spoken in foreign language].

Let me translate on this. The main point is that, from the current NetEase portal, we have a lot of traffic in both, like, the emails, blogs and content. And all of this traffic, after we launch our search in the third quarter, we will try to guide all these users to try our new search engine. And with the technology that we have built, we believe that this search engine will become the first choice for search engine for all our NetEase users.

Yes. Okay, thank you.

Okay.

[OPERATOR INSTRUCTIONS]. Next, we'll hear from Wallace Cheung of Credit Suisse.

Hi, morning. Greetings, Michael and Onward.

Hi.

Good morning.

Yes. [Spoken in foreign language]. My two questions, actually, firstly on Tianxia II. I think -- Can you explain a little more on the reason why you have delayed launch and also how is the re-launch schedule? What kind of features are you going to improve? And secondly, on the advertising revenue side, can you explain why, since the revenue is actually behind the [period] from -- in the first quarter? Thank you.

Okay, Cheung. Let me answer the question first. For Tianxia II, I think one of the biggest disappointments for us is that the game-play that we have designed has been very focused on the advanced level. And what has been really disappointing for us is that a lot of the users in the game, basically, they are not able to achieve those levels, because [before] they really enjoy the fun part of the game and they're left in the beginner's level. And it also reflects that we have not done a good job in [inducing] these users to the advanced levels.

We continue to believe there are a lot of really hardcore fans of our games, as we can see from different surveys and also from our bulletin boards and so on. And so, right now, what we are doing is -- Let me explain more on the reason first. It's not because of the hardware requirement, which somebody has been talking about. The hardware requirement, we believe we have streamlined it and it should not be a problem for the gamers. It's really because of the game-play itself, which --

We have done [inaudible]. We [have] been doing very well on that. What we are doing right now is that we are having a redevelopment for the game. We are going to redevelop the beginner levels. It is already in the press release that we have introduced new members to the teams and we want to bring in more new ideas in how to induce our beginner users. So that's for Tianxia II.

And then for the advertising revenue, as we also mentioned in the script, basically, what happened is that industries such as the e-commerce industry, which we have -- we used to heavily rely on, hasn't been doing very well during this quarter. So I think -- And that's really it. The traffic of the -- of our products, the portals, the emails and so on has been doing well and so has the growth of the advertising. And in other industries has also been doing well.

So -- And there is another reason. Another reason is that the search -- the current search revenue has also been dropping and that is simply because that we have now focused our energy more into our in-house developed search, rather than the current partnership with Google right now. So there are two reasons. One is the search advertising revenue and the second is the e-commerce industry. [Spoken in foreign language].

[Spoken in foreign language].

[Spoken in foreign language].

[Spoken in foreign language].

[Spoken in foreign language]. Yes, please, Wallace.

Okay. [Spoken in foreign language]. My question is, actually, will NetEase develop [own] 3D game engine [can] improve Tianxia [or] the [game-play]? Thank you.

[Tianxia], no. It has no relationship with the engine. It's really, as we have mentioned, the game-play that we have made kind of a mistake in that area. It's not really related to the engine.

Okay, thank you. [Appreciate it].

Thank you.

And we'll take our next question from Lin Shi with Lehman Brothers.

Hi. Good morning. Thank you for taking my questions. The first question is regarding Westward Journey II. Just now, as you mentioned, [the Fantasy] actually delivered growth in revenue by 15%, so it might imply there has been a decline in Westward Journey II. So just wondered, before the Westward Journey III can be -- can bring in additional revenue, whether there's any expansion pack or any sense about Westward Journey II.

To simply put it, for Westward Journey II, the growth of revenue on first quarter versus the fourth quarter is a decrease of 5% and the growth of Fantasy Westward Journey for the same quarter's comparison is a growth of 12 -- 11.8%, actually. So that's the facts, okay? And it is true that Westward Journey II experienced a decrease in this quarter, but I think - you've been following this for a long time - that Westward Journey II has been up and down. We have seen quarters that it has decreased for 5% or so but -- and then the next quarter, all of a sudden, grown by 2% or so. So I would say, in general, it's a flat [game] right now.

What we are seeing in Westward Journey III is because of -- The game is quite -- completely new. The graphics are completely new, while the game is an extension of Westward Journey II. We believe that the game will be able to attract new users as well as retaining old users. So we don't know how many new users we can attract, but we do look at it, at least from the marketing point of view, that we are looking at it as a new game. So that's for Westward Journey III. Shi Lin, did I answer your question?

So you don't plan any expansion packs before the launch of Westward Journey III?

No, because the internal beta -- internal closed beta for Westward Journey III has already started and we are looking at the open beta by the second half of this year.

Okay, understood. My second question is regarding the search business. I'm not sure whether I'm looking at the right page. I'm looking at [udoor].com. I notice that you feature the blog search and dictionary search. My question is, basically, there are quite some search engines available in the market and, as a latecomer, what would be your strategy in terms of user experience or focus or functionality of your search engine to gain user traffic?

William?

Yes.

[Spoken in foreign language].

[Spoken in foreign language].

[Spoken in foreign language].

[Spoken in foreign language].

Okay. No problem. My last question is regarding the minority interest. I noticed there's no minority interest as compared with last quarter, so what's the reason?

Okay. Let me explain -- Let me translate what William just said, first, and then I'll ask Onward to explain on the minority interest, okay? So, basically, our search engine is still in kind of an open beta mode right now. It's true that you can go into the domain name and try it out, but a lot of the new functionalities and the uniqueness of the search engine we haven't released yet. So it's really competitive information right now, but once we release, please do take a look at it and you'll know the difference and the uniqueness of the product. So, on the minority interest --

Basically, regarding the minority interest, why there is no figures in this quarter, mainly because the share of [flows] of the minority interest is already being absorbed by the capital contributions by the minority in the previous quarters. And so the whole sum is being used up and so there is no further minority interest being reflected in this quarter.

Okay. I guess we have to take our next question. Sorry.

Okay. Thank you very much. Thank you.

Okay.

We'll move on to Dick Wei with JP Morgan.

Hi. Good morning. Thanks for taking my questions. I've got two questions. First question is about your game development plans. Can you talk some more about your -- the current R&D team size, like I understand also you have a number of studios open around the country? And can you also talk about the game pipeline and the launch date? Thanks.

Okay. We have around 1,000 game developers right now over the country, including studios in Guangzhou, Hangzhou, Shanghai and also in [Chen Do]. For the games pipeline, I think we have mentioned in the previous conference calls we have games for MMORPGs, advanced casual games and also some other casual games. But that includes, of course --

For the timeline, let's take Westward Journey III as kind of the -- things after Westward Journey III. We have Fly for Fun. We have MMORTS and RPG games. We have some advanced casual games as well. So we are looking until end of 2007 or in 2008, but it's too early to say right now what those games are, exactly, and exact timeline for those games.

Is it possible, roughly, to separate the number of R&D staff in Westward Journey II, Fantasy and Tianxia, or how many are looking into the future games?

We do not really look at our team this way, because we have been pooling our resources together, so, for example, our graphics artists or the programmers. So today, for this week, they may be working on Westward Journey II, but the next week they might be working on another project. So it's really difficult for me to define it the way you think about it.

Okay. That's great. And my last question is can you talk some more about the longer-term strategic plans for NetEase, a couple years down the road? Is it maybe games or what other strategic focus the Company has right now the long term?

Can you be more specific?

I think just beyond the current in-house development [games], I think you guys are trying to put more focus on search and also on the advertising. And I just want to see which are the -- probably the more -- the more of the growth driver or the more of the stronger focus that the Company has.

Yes, I think just put it into three different areas. One has continued to be the games. It could be game -- in-house developed games. It could also be licensed games that we have mentioned our interest or active participation in licensing games in the last quarter conference call.

And then, on the advertising side, it's really based -- built -- On the branded advertising side, it's really built on the portal, including the traffic generated from the content development -- the content channels development, the blogs, the emails, which are applications on the internet that also generate traffic. And the third, really, is on the search, where we are going to launch in the second half of this year, which we believe is a new area for us. We have a lot of confidence in it, but be minded that we -- Frankly, we do not see material commercialization of the search at least in '07.

Great. Thanks a lot.

Thanks.

Our next question comes from Jason Brueschke of Citigroup.

Thank you. Good morning, gentlemen. And may I start by conveying my best wishes to Denny on his future endeavors? I've enjoyed working with him over the last few years. Let me -- Maybe three quick questions. First of all, could you -- This is a follow-up to an earlier question. Could you maybe give us some sense of the timeline that you guys expect to fix the problems with Tianxia? Is this -- Is it a six-month fix? Is it a three-month fix? Is it a nine-month fix? Based upon what you know and the teams that you hired, what do you think that will be?

Okay. And the next question?

Okay. The next question is on advertising. Given your demographics, you compete pretty heavily head to head with Tencent. In April, they announced a $5 to $8m advertising campaign to enhance the brand of their QQ portal. I was wondering, in light of your indications that you guys are willing to spend more going forward on sales and marketing, would you plan to do something similar to enhance a lot of the new content and channels that you have, so that the advertisers out there are aware of it and can help accelerate their advertising?

And then my final question is with respect to Fantasy. I was wondering if you could just help us understand how much of the strength in Q1 was due to the expansion pack plus the marketing efforts that you did in promotion and how much of it was due, say, to the Valentine's Day holiday and things that won't necessarily repeat in Q2? Thanks.

Okay, sure. I think, for Tianxia, I'm sorry, we cannot give you a very specific timeline, but all I can say, it is in the range of what you have mentioned. So -- But it's -- Obviously, it's not very specific.

So -- And on the next question, on the advertising, I think the market definitely has generally seen that our content has really improved a lot and we are really experiencing a lot of growth in the content area. I think we -- In some way, we are not really competing with Tencent in a way, because Tencent continue to rely a lot on their advertising revenue on the IMs, which we have -- Our PowWow is a much smaller compared to Tencent.

But, on the other hand, our content has been built and is much stronger than that. The portal, the dotcom itself, has been much stronger than that of Tencent in terms of the content, quality and so on. So I don't -- I wouldn't say that we are really competing head to head right now. And we are fully confident that our advertising revenue will continue to grow, although there is some problem that I have mentioned or explained just now.

And then, on the Fantasy Westward Journey, I think it's really hard to separate between the Valentine's Day or the expansion pack or the marketing. But I would say that the Valentine's Day, it is the day that we experienced the new PCU of $1.5m. We see a lot of new users coming in [that day]. But it's really difficult to say what's the percentage or the contributions, to divide or to separate between this and the expansion pack or the marketing.

Okay, great. You may have mentioned this, but could you give us the ACUs for Fantasy and Westward Journey v2, please?

Yes, of course. ACU. The ACU figures for the first quarter is around 16 -- 170,000 for the Westward Journey II. And the ACU numbers for the Fantasy Westward Journey is around 500,000. 510,000.

Alright, thanks, guys.

Okay, thanks.

Our next question comes from Tony Gikas of Piper Jaffray.

Hi. Good morning, guys, and thank you for taking my calls. A couple of questions. Any update regarding licensing opportunities? You talked about that on the last call. You mentioned it again today. Is that something that we should expect to see later this year, or is that more of a 2008 catalyst?

Second question, could you just give us a little update on industry growth trends and do you expect to return to industry growth levels in 2008? And if so, when would you expect that revenues would start to accelerate? And then I have a couple of follow ups.

Yes, sure, of course. I think all I can say is that, for the licensing business, that we are active in looking at licensing opportunities right now. But -- I am sorry that there is nothing that we can comment more, because there is no -- We don't have any news that we can disclose or publicly announce right now, but, definitely, we are having very active participation in the market right now, versus a year ago or so.

On the industry growth, I think we are still looking at -- Can I assume that you are talking about the game market?

Yes.

Okay. I think we are still looking at -- The industry, we are looking at like 30% plus growth in the '07 and '08 per year and I think -- Can we get back to industry growth? I think yes, definitely, but I think it really depends on when we have the new products coming out. I think Westward Journey III is an interesting product that can help us to attract new users. We continue to believe and have a lot of confidence in Tianxia II when it is redeveloped. But obviously, all this takes time, so will it be a mid '07 event? I don't think so. But is it something in '08 or so? I think it's possible.

In terms of licensing opportunities, are there a number of attractive properties out there that you're seeing, or are they relatively limited at this point?

There are. There are numerous opportunities out there from different countries. It could be from Korea, Japan or in the United States. It is clear in the markets that there is continued to be good opportunities in licensing as well and, as we have mentioned, that we are actively participating in those.

Okay. And then you gave us where the share repurchase was at the end of the quarter. Can you update us on where you are with the share repurchase as of today?

We cannot mention until today, but we can repeat what is up to the end of first quarter.

Yes. Basically, this is just as what we have mentioned earlier in the call today that, for the share repurchase program that we have authorized -- the Board have authorized on March 13 about the $100m share repurchase. As of March 13 --- 31 of 2007, we have already purchased about 1.1m ADS with an aggregate purchase consideration of about $20.8m, whereas, on our other share repurchase program of $100m being authorized on August 28, 2006, we have repurchased about 3.6m ADS with an aggregate purchase consideration of $60.1m.

Okay. And any visibility, or maybe help, on -- in terms of modeling advertising revenues next year, as those opportunities should start to improve?

As we mentioned, we continue to see the advertising business as a very good healthy business going forward, but I don't know in what way I can help you to model it. Anthony, I'm sorry, but I guess we need to take some other calls. Quite a few other people are still lining up.

Okay. Thank you.

Okay. We'll talk later. Thanks.

Next, we'll hear from Evan Wilson with Pacific Crest.

Hi there. Good morning. Two questions, first related to the sales and marketing expenses. You indicated an increase both for the proprietary search engine as well as increased spending on massively multiplayer games going forward. I was hoping you could help us quantify exactly what type of increase that would be and how it would [relate] to the model.

Second, on the gross margin in the advertising business, how exactly should we look at that business going forward? Is this a new run rate or do you plan a near-term rebound in sales, or maybe cost cuts, one of those? Could you help with your strategy there or exactly how to look at the gross margin? Thanks.

Okay, sure, of course. I think the way you can help you to look at the sales and marketing for the going-forward projects, for example, for this quarter, we have explained that the launch of Tianxia we are looking at around $0.8m. I think you can look at it this way, that our mixed marketing program, for example, for Westward Journey III, it could be a bit more aggressive. We look at this kind of range, okay?

Then, for the gross margin of advertising revenue, it very simply is -- the content itself is -- the cost is really a fixed cost. It's mainly the people costs and the content purchase costs and those are really fixed costs. But the revenues do fluctuate from quarter to quarter. The first quarter is usually, seasonally, our lowest quarter.

So I really expect this gross margin experienced in the first quarter be a very low one and we believe that we will see improvements in the second and the third quarter, where we -- seasonally, those are good quarters. We don't expect this to be a continued run rate for the gross margin for our advertising revenue.

Thanks very much.

Okay.

Our next question comes from Ming Zhao with SIG.

Okay, thank you. Good morning. [Busy] two questions. First question on the search, I want to ask you -- You're developing your in-house search engine. Does that mean your partnership with Google will end sometime second half of this year? And also, relating to the search, how much of the search traffic on NetEase search engine is from the portal content channels and how much is directly from people going directly to that so.163.com? [Spoken in foreign language].

[Spoken in foreign language].

Right. Let me translate a bit on this. The answer to the first question is correct, that, when we have our own search engine to be released, then we will terminate the contract or the current partnership with Google. Secondly is that, right now, we have not marketed our search engine at all in our 163.com. It's really irrelevant to look at the traffic pattern or so in the website right now.

Okay, thank you.

Okay, thank you. I think we can take two more questions.

We'll move on, then, to James Mitchell with Goldman Sachs.

Right. Hi, James.

Hi. Thank you for taking my question. If I'm a really keen, enthusiastic player of Westward Journey II and I'm currently paying you RMB20 a month to play Westward Journey II and then, as soon as Westward Journey III is available, I instantly switch to Westward Journey III to enjoy the open beta of Westward Journey III as soon as I can, does that mean that there'd be a one- or two-month period in which you previously collected money from me paying for Westward Journey II, but you wouldn't collect money from me in the open beta for Westward Journey III? Or is that not correct?

We do not have exact trends right now on this, but the simple answer is that the open beta of Westward Journey III will be taken in steps, where we will -- taken in stages, where we will expand it slowly by slowly. And also that, basically -- or the answer to your question is no, that -- because, for Westward Journey II players right now, if they want to migrate their user data to Westward Journey III, then we will ask them to migrate when Westward Journey III basically becomes commercialized. That's really as simple as this is.

But of course, if they want to become a new player in Westward Journey III, then you are right, then they become an open beta user. But then they will have problems in migrating their experience points and so on. But you have -- I can comfort you on this that a lot of the users will want to take their experience points and so on to migrate into Westward Journey III. And at the same time, we will make sure that Westward Journey III open beta will be taken in stages, where we will have the distribution and the coverage mixture before we actually commercialize it.

Okay, that puts my mind at rest. And then just to confirm, I think in the past I've been under the impression that the first quarter was seasonally a strong quarter for game revenue, because of the holidays, and the second quarter was seasonally a little bit slower, because of the examinations. Is that [your experience, do you think, or is it too soon to say]?

Yes. Seasonally, the first quarter is always pretty good, actually. But then, the second quarter, we still have the national holiday, although combined with the exams, and then we have the summer holidays in the third quarter.

Cool. Thank you very much.

Okay?

Yes.

Thank you.

We'll take our final question from Tian Hou with Unterberg Towbin.

Thank you for taking my question. The question is regarding operating models for the new games coming to the market. Are you still going to do pay to play or you're going to change the model to free to play? [Spoken in foreign language].

We are open. Basically, we will have games that will continue to be fee-based and we will have games that could be item paid.

So for the new games, like Westward Journey III -- So is that going to be pay to play?

We haven't decided. But basically -- Basically, it will be a pay to play game, so it's a subscription-based game. But then,. we will have other games that we will be addressing the market of free to play or item based games.

Okay. The last question would be RMB. The RMB dollar in Q1 was [inaudible] of Q4. So going forward, do you expect RMB dollar [to go up] dollar-wise going to be higher than Q1 or in a similar range?

I think that would be a bit too early to comment on the future trends of the RMB movements, but I think that we can still chip up our RMB balance at the current level.

Thank you.

Yes. I think that concludes the Q&A session.

Okay, everyone. Thanks again for joining us. Please feel free to contact us if you have any questions.

And again, ladies and gentlemen, we do thank you for your participation. That does conclude today's conference.