NetEase Inc (NTES) 2009 Q1 法說會逐字稿

Good evening, ladies and gentlemen. Thank you for standing by. Welcome to the NetEase first quarter 2009 earnings conference call. During today's presentation all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). This conference is being recorded today, Wednesday, May 20, 2009.

I would now like to turn the conference over to Brandi Piacente, Investor Relations for NetEase. Please go ahead, ma'am.

Thank you, operator. Please note the discussions 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 US Private Securities Litigation Reform Act. Such statements are not guarantees of future performance, and are subject to certain risks and 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 are 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 over to Onward Choi, Acting Chief Financial Officer, who will read the prepared remarks on behalf of Mr. William Ding, Chief Executive Officer of NetEase.

Thank you, Brandi. Total revenues for the first quarter of 2009 were $114.4m, compared to $117.3m in the prior quarter and $95.4m in the first quarter of 2008.

Our online game business continued to perform well during the quarter as a result of the longevity of our game lifecycles, strong user loyalty among our gamers and robust online communities.

In the first quarter, revenues for our online game business totaled $106m, compared to $98.4m in the previous quarter and $81.4m for the first quarter of 2008.

Fantasy Westward Journey maintained a steady user base throughout the first quarter with PCU and ACU of 1.75m and 640,000, respectively, compared with 1.8m and 625,000 in the fourth quarter, respectively.

PCUs and ACUs remained healthy in the first quarter, due to the successful executions of marketing campaigns and strong user community. We are planning a variety of promotional activities via diversified channels in the upcoming summer season to reinforce the long-standing popularity of Fantasy Westward Journey and promote its appeal to new gamers. Fantasy Westward Journey has been in operation for five years and is still one of the most popular games in China.

The performance of Westward Journey Online II is another indicator of our brand's longevity in the marketplace. PCUs and ACUs for Westward Journey II were 606,000 and 217,000 in the first quarter, respectively, compared with 897,000 and 197,000 in the fourth quarter, respectively.

Recently introduced promotional activities to enhance game play continue to attract new users and retain existing players, and we plan to continue releasing expansion packs in due course to further enhance this game's appeal to our users.

Westward Journey II's number of online registered users has remained steady. In March, we introduced promotional activities to enhance the game play, which has helped attract new users and retain existing players. We plan to release the game's tenth expansion pack this summer. We have also been working on a series of adjustments to Westward Journey II's game play and plan to release a new expansion pack in the second half of 2009.

The development of and performance of Tianxia II has been progressing well. The numbers of both new and paid users are growing as expected. And we are planning to release a new expansion pack around the end of the third quarter of this year.

Our development team is also working well on the productions of Heroes of Tang Dynasty, which is progressing through closed beta testing. We have addressed certain technical issues in a timely manner and expect that we will be able to expand the scale of our closed beta testing during the third quarter this year.

New Fly for Fun's closed beta testing has been going smoothly. Based on users' feedback and interactions, we have successfully helped new game players familiar with the enhancements of the game play design. We have begun open beta testing of this game on May 15, 2009.

Diversification of our game product offerings through strategic licensing opportunities is an integral part of our long-term growth plan. Our most exciting recent success was the expansions of our partnership with Blizzard Entertainment to license World of Warcraft in mainland China. This agreement is for a term of three years following the re-launch of that game after the expirations of the current license agreement.

This new licensing achievement adds to our existing licensing agreements for other Blizzard Entertainment games like Warcraft III and StarCraft II and the Battle.net platform. We are now positioned with the most popular MMORPG worldwide in additions to our outstanding portfolio of market-leading in-house developed games. We will update you with more details about our relationship with Blizzard as events warrant.

Turning to advertising, revenues from advertising services were $6m for the first quarter of 2009, compared to $16.4m and $11.3m for the fourth and first quarters of 2008, respectively.

While advertisers remained cautious overall during the first quarter as the global economic slowdown continued and as reflected in the decrease in our revenue from advertising services, the Chinese government's stimulus measures and continually expanding internal consumptions power have delivered some initial signs of recovery.

To accommodate future market stability and an expected return to online advertising spending growth later this year, we remain on plan to complete several new products and upgrades to our existing channels and add new channels by the end of the first half of 2009 to create more premium ad space for our advertisers.

In search, we've seen steady growth in Youdao's usage with Web search traffic increasing 90% year-over-year from the first quarter of 2008. Although our user base is still relatively small, this statistic shows that more users are adopting Youdao over time.

Total installations of Youdao's dictionary software just surpassed 10m at the end of the first quarter. In January, we launched beta testing of Youdao's shopping search as an answer to the increasing need from Chinese Internet users for convenient shopping outlets online.

Our product is designed as a gateway for users to reach various shopping sites through our search technologies. It provides features such as price comparisons and user reviews of shopping sites so that users can make faster, more informed shopping decisions.

We will continue to execute our strategies to build Youdao.com as an important Internet starting point for Chinese Internet users and continue to provide high-quality vertical and software products based on Youdao's search technologies to our users.

That concludes William's remarks. Now I will provide a review of our first quarter 2009 financial results using numbers and percentages based on US dollars. In order to avoid repetitions with the press release, I will primarily focus on the discussions of margins and expense fluctuations along with (technical difficulty).

Gross profit for the first quarter of 2009 was $93.9m, compared to $93.5m and $77.9m for the fourth and first quarters of 2008, respectively. The slight quarter-over-quarter increase in gross profit was primarily attributable to the continued strong revenue growth from our flagship games, Fantasy Westward Journey and Westward Journey II, as well as Tianxia II, coupled with cost savings on staff-related costs in the current quarter, which was largely offset by the significant decrease in advertising revenues.

The first quarter is normally a low season for the advertising industry in China, especially in 2009 due to the global economic slowdown, and many of our advertisers delay or reduce their advertising spending.

Gross profit margins for the online game business for the first quarter of 2009 were -- was 90%, compared to 88% and 90.2% for the fourth and first quarters of 2008, respectively. The quarter-over-quarter increase in gross profit margin was primarily due to cost savings on staff-related costs. The year-over-year gross profit margin remained relatively stable.

Gross loss margins for the advertising business for the first quarter of 2009 was 13.1%, compared to gross profit margins of 51.1% and 45.8% for the fourth and first quarters of 2008, respectively. The quarter-over-quarter and year-over-year decreases in gross profit margins were primarily attributable to significantly reduced advertising revenues in the current quarter as explained above.

Gross loss margin for the wireless and value-added services and others business for the first quarter of 2009 was 22.3%, compared to 24.9% and 6.2% for the fourth and first quarters of 2008, respectively. The quarter-over-quarter gross loss margin remained relatively stable. The year-over-year increase in gross loss margins was mainly due to a reduction in revenues from SMS services, partially offset by increased revenues from premium email services.

Total operating expenses for the first quarter of 2009 were $22m, compared to $24.7m and $18.7m for the fourth and first quarters of 2008, respectively. The quarter-over-quarter decrease in selling and marketing expenses was primarily attributable to reduced sales and marketing promotion costs related to games and advertising services, and reduced staff-related costs.

The quarter-over-quarter decrease in research and development expenses was primarily due to a reduction in bonus accruals. The foregoing decreases were partially offset by increased general and administration expenses resulting from increased provisions for bad debts over -- on overdue accounts receivable balances and increased headcount and game management staff-related costs.

The year-over-year increase in selling and marketing expenses was mainly due to increased temporary staff costs for promoting online games and increased promotional activities related to advertising services in the current quarter.

The year-over-year increase in general and administration expenses were mainly caused by increased provisions for bad debt and increased headcount.

The year-over-year increases in research and development expenses was mainly caused by higher depreciation expense related to additional servers acquired to develop online game and search engine services and increased bandwidth usage and server custody fees, resulting from increased usage by the development teams of online games, advertising and search engine areas.

Net profit for the first quarter of 2009 totaled $61m, compared to $84.3m and $39.4m for the fourth and first quarter of 2008, respectively.

During the current quarter, we reported a net foreign exchange loss of $7m compared to $3.2m and $7.4m for the fourth and first quarter of 2008, respectively. The quarter-over-quarter increase and year-over-year decrease in foreign exchange loss was mainly related to the translation loss on euro-denominated bank deposit balances as of March 31, 2009, as the exchange rate of the euro against the RMB fluctuated over the periods.

Basic and diluted earnings per ADS were $0.48 and $0.47, respectively, for the first quarter of 2009. This compares to basic and diluted earnings per ADS of $0.66 and $0.65 and $0.62 (sic -- see press release) and $0.30 for the fourth and first quarters of 2008, respectively.

NetEase maintains a very strong balance sheet with ample cash resources to fund our ongoing development of world-class online games and premium online content and our third-party licensing arrangements.

As of March 31, 2009, cash and time deposits totaled $882.6m, compared to $821.5m as of December 31, 2008.

Cash flows generated from operating activities totaled $83.1m for the first quarter of 2009, compared to $75.2m and $72.4m for the fourth and first quarters of 2008, respectively.

As of March 31, 2009, we have spent, in aggregate, total purchase considerations of approximately $13.1m, including transaction costs for our share repurchase program.

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

(Operator Instructions). Richard Ji with Morgan Stanley.

Hi William, Onward. And a great quarter, congrats. I have two questions.

First, starting with World of Warcraft. It is clearly a milestone for your Company in acquire this leading 3D game in the world. And I'm just curious about the transitioning of World of Warcraft. Can you give us some update on the status for the transition right now and would you expect any customer churn during the transition process? And when do you expect the sales to reaccelerate for World of Warcraft? And the relative current revenue level, and would you expect you can potentially produce more revenue for World of Warcraft in the years to come? Thank you.

Maybe I'll just give you an update on the transition arrangement of operating the World of Warcraft for the time being. Basically, the transition planning is still well underway and we are still working closely with all relevant parties to make sure the transition goes on smoothly.

And for the time being, I think there are periodic updates on our designated website to facilitate peoples to understand how the transition is progressing. And I would suggest you to visit our website at the wow.163.com to stay up to date on these matters.

But for the time being, I think this is still our top priority, to ensure that the overall transitions will be as smooth as possible and so that we, just to align with what the Company is always aiming and focusing, to ensure the gamers' experience would be ensured through these transition arrangements.

And with regard to the potential financial impact that would come along in bringing up these games to NetEase, I think we would rather to focus -- of course, we are very positive about the development and growth of this game going forward. But more importantly, we think that all games and business-related decisions will be guided by our commitments to providing our players with the highest-quality entertainment experience. This is more important. And we recognize that our games would have never achieved the popularity that they have around the region without the support of our players. And so this is how we think currently, that we are working on -- very hard to make sure that this would happen nicely.

And also, William, given the strengths of your R&D team, would you expect yourself to be heavily, or your team to be heavily involved in the rollout of expansion pack in the future for World of Warcraft?

(Spoken in Chinese).

Perhaps I can just do some quick translations on what William has just highlighted in his reply to Richard's questions regarding how far the companies would -- given we have a very strong research and development capabilities, would there any ways that we would participated in the developments of the expansion packs for the World of Warcraft going forward. And basically, as all of you may well aware of, the licensing cooperations with Blizzard have just started. And the Company is currently making much efforts to make sure that the transitions will be going up as smooth as possible.

And so far the Company does not note out any operational issues or problems relating to the smooth transitions of taking up this game. But just as what we mentioned earlier, we do understand that. We have a very strong R&D teams. And given our previous track record -- and so we believe that in the upcoming expansion packs, especially on doing the localization versions of the expansion packs, we do -- we're [positively] that very good products will coming out to the market.

Thank you, William, Onward, very helpful.

Okay. You're welcome.

Wallace Cheung with Credit Suisse Global.

Hi. Good morning William, Onward.

Hi Wallace.

Hi. (Spoken in Chinese). So my question is like -- my first question is why Blizzard chose NetEase to operate World of Warcraft? And how can -- NetEase can improve the game operation going forward?

And second question is, what are the synergies between operating World of Warcraft and StarCraft and Battle.net, as well as the resources allocation in the future? Thank you.

(Spoken in Chinese).

Perhaps I translate what William has just mentioned just now. For the first question, I think basically NetEase has been very strong in protecting the accounts of those players and has put a very much importance and -- on our priorities in making sure that all the players' accounts can be protected without being stolen or something like that.

And also, so far, given our previous track record, we have already issued over 8m kinds of tokens to successfully protect the benefits and interests of our users. And so, from that angle, I think that this is a very strong point to -- in making sure that we have a competitive advantage in this respect.

And for the second question, about the resource allocations on operating both the StarCraft II, Warcraft III and also the World of Warcraft. Basically we'll -- the StarCraft II and Warcraft III would be the real-time strategy games, whereas the World of Warcraft would be another type of the MMORPG games. Those types of games would deploy different kind of resources. But given our competence in our technical side and also the customer satisfies, we do believe that we can serve our players up to their expectations and perhaps -- and also exceed their expectations.

(Spoken in Chinese). So my question is, can management explain a little more on the difference between World of Warcraft and StarCraft in terms of the targeted users' demographics, as well like the operating approaches, promotion approaches. Is there any difference between the two games? Thank you.

(Spoken in Chinese).

Regarding about the type of players for -- and the demographics of the players who are going to play the World of Warcraft or the StarCraft II, basically the World of Warcraft is just a MMORPG games, focusing on the -- a group of players to do some teamwork to resolve some of the problems or issues, or do some projects within the game environment. Whereas for the StarCraft II, this type of game is more focusing on the competitions with different players, sometimes maybe just a few, two to five players at one times. And they will take -- they will need to accomplish a certain kind of task or to complete the games, say, within 20 minutes or something like that.

And so from that, these two type of games would serve different type of players. And so there wouldn't be any conflict in them. And also, this would contrast with the different kind of music -- musical that we will be enjoying, perhaps some -- maybe some traditional music and the more popular musics. And so we do believe that there wouldn't be any big similarities in the users of those two games, but rather this will serve different kind of players.

And also, for the pricing method of these two games, of course those two games would also adopt a somewhat different kind of model. But for the time being, of course, we wouldn't think that this would have any much impact on the players.

Thank you very much.

Dick Wei with JP Morgan.

Hi. Morning William and Onward. Thanks for taking my questions. I've got several questions.

First one is can you update us on the games pipeline for the rest of the year? And then secondly, if you -- I guess William was just mentioning about StarCraft and Battle.net. I wonder if you can elaborate more on the business model.

And then thirdly, just on the server CapEx for the -- related with the World of Warcraft. I saw the news that you guys will be getting a lot of new servers. So I wondered about what is the approximate CapEx for that. Thanks.

Maybe I'll just give you some updates on our --

(Spoken in Chinese).

Perhaps Dick, maybe I'll just give a recap on what William has just answered for the first two questions regarding the game pipeline. In this year, the Company will be more focused in delivering a couple of new games given our experiences of developing the games so far. And in a nutshell, I think for this year, we will launch two MMORPG games and one would be 2.5D and the other one would be 3D, two casual games and also one Web based games. And hopefully, more marketing efforts or more announcements will be made towards the third quarter of this year. And so we will keep you guys updated as and when this happens.

And for the second question about the potential business model on operating the StarCraft II and the Battle.net, I think basically, NetEase and Blizzard are still currently working very hard on designing how this would happen. When it is put out to the market, we'll keep you guys updated as the development progresses.

And with regard to the potential CapEx on the World of Warcraft and also the servers, I think there is no exact numbers that we can give out for the time being. But what I can give you a sense is that keeping the existing scale of operating World of Warcraft we already deployed sufficient and enough resources to build our own infrastructures to making sure that upon the smooth transition of this game to NetEase, we can provide a very good service to meet the demand of our players.

(Spoken in Chinese).

Alicia Yap with Citigroup.

Yes, thank you. Good morning, Ding (inaudible) and Onward. I have a couple of questions.

My first question is also regarding your transition for World of Warcraft. Can you actually update us whether you have obtained the publishing rights from the Chinese government to operate World of Warcraft?

And then for the Wrath of Lich King expansion pack, does that require going through another separate approval process? I have two follow up.

(Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese).

Okay, perhaps I can just give a quick recap on what William has just answered about -- regarding the transition of the World of Warcraft, whether the Company would need to get the license rights from the relevant authorities. Of course, for the World of Warcraft, this is an imported game and we are all aware that the current license agreement would -- due to be expired in early June this year and transferred to a new operator.

And so we will follow the relevant rules and regulations and do the applications with the relevant authorities to make sure that we get the rights to operate these games.

And for the second question about the Wrath of Lich King, whether -- when we can get the approval of operating this game because the current license will only be expired in early June this year, and we would also need to wait until then that Blizzard would grant us the relevant rights to do the further processing and also the proceedings with the government authorities to get the approval. So we'll still wait and see for the time being.

Okay, thank you. And my second question is also regarding the World of Warcraft. So if the World of Warcraft will be operated under the JV structure or as the subsidiary of NetEase? So if we assume that we are going to recognize the revenues on a consolidated basis, how should we assume the gross margin going forward?

(Spoken in Chinese).

Okay. According to the PRC law, the online games could only be operated by a domestic company owning an ISP license. And so definitely, the operations would be done by the NetEase companies.

Regarding the gross margin, can you actually tell us a little bit of color on how that will affect your gross margin going forward?

With regard to the gross margin, I think at that moment, I think we are still working on with the Blizzard side on the deal to make sure that the transition would go as smooth as possible. And I think we will give you some updates perhaps, maybe at a later stage, when we get more of those stuff finalized. And we'll keep you updated.

Okay. Now this is a question to William. (Spoken in Chinese).

I'm sorry. My last question for William is what are the biggest challenges that you see managing and running NetEase right now?

(Spoken in Chinese).

I think -- William has just highlighted that basically, he is still feeling quite satisfactory about the overall progress in managing or operating the companies. And in particular, with regard to the upcoming operations of the StarCraft II, given the -- a very well user base and also the marketing channels, we are still holding a positive view about the operations and the business going forward.

Okay, thank you. I'll get back on the queue.

Eddie Leung with Bank of America.

Good morning William and Onward. I have a couple of questions. The first one is could you elaborate more on some of the new promotion channels for your existing games? (Spoken in Chinese).

(Spoken in Chinese).

With regard to the promotional channels on promoting the Company's games, I think the Company has always been exploring different kind of ways to do the promotion or the marketing of our products. And we also have a very effective assessment system making sure that whether a particular type or kind of promotional channel is good to adopt or not. And so from the angle, I think we would still keep up this kind of methodologies in doing our promotional effort.

Okay. And my second question is on the portals, are we going to see some new content or new information channels on your portals going forward and what are they? (Spoken in Chinese).

(Spoken in Chinese).

Just as what William has just highlighted, although the Company's first quarter performance on the -- sorry. Although the Company's first quarter advertising business performance is not very satisfactory, but from our existing user base and also the web traffic so far that we have noted, the management and the Company is still -- feel comfortable about their performance and also are holding a positive view about this part of the business.

With regard to the content or the channels delivery, of course, the Company would still hold up -- keep up its investment in giving out more quality content to the target audiences. And of course, we would try to work on some exclusive kind of stuff including the sports kind of information. And also, we are always deploying sufficient resources and try to do some product integrations with regard to our [portal], email and also search platforms.

Okay, thank you very much.

Ming Zhao with SIG.

Thank you for taking my question. Good morning William and Onward. The first question is some report said that you have changed your revenue sharing schedule with the prepaid card distributor. Can you clarify that? Is there any impact on your business? (Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese).

With regard to the questions regarding the revenue sharing of the point card to the distributors, the Company has changed the discount policies from the previous 14% discount and decreased to just offering a 10% discount to the distributors. But having said so, we do still believe that the impact on the distributors would be minimal because the distributors would be -- care or worry more about the risk of selling those point cards. And so far, the sale of the point cards of NetEase wouldn't be posing any problems to its distributors. And so we still believe that the impact to the distributors would not be that much and would be minimal.

Okay, thank you. My second question is about your advertising business. So in addition to the macro environment and the advertisers' hesitation to spend, was there any unusual thing that happened in the first quarter. I'm asking this because the last time you had $6m quarterly revenue that was in 2005. So that is my second question. (Spoken in Chinese).

(Spoken in Chinese).

We still believe that although the macro environment is not very good and having -- given the fact that we do have some relocations from the [Guangzhou] to Beijing with regard to the portal business, we still believe that our discount impact would be temporary and wouldn't be for long. We are still positive about the business going forward.

Okay, that's good. (Spoken in Chinese). So my last question is, is there any impact from competitors' game [AEON]? Thank you.

(Spoken in Chinese).

Okay, maybe I just recap on what William has just said. William would like to make a supplement response with regard to Ming's first question which is that with regard to the web traffic and also the growth on the user base, we still looked at that and there has been a very good and healthy progress so far. And so from that, it would add up to our confidence about the future of our portal business going forward.

And with regard to Ming's second question regarding would there be any impact of AEON on NetEase, William's view would be that given the past couple of years of our business operations in China, we still believe that a very strong technical skill capability and positions would be very great [core] factors in making sure that the success in running the business especially for the online games.

And so far, for the AEON games, because it has just launched in the PRC for just a very short time and so the overall impact has yet to be seen. But we still believe that from what we have done in the past, say for example, the Tianxia II, we have previously first launched the games to the market and note if there are any problems. And then we will just take it back and do some refinement and enhancements to the game itself. And after our second launch of this game, so far the progress is very well. And so this in some ways would substantiate and support our saying that very strong technical capabilities would ensure the continued success of online gaming companies.

Thank you very much.

Tian Hou with Pali Capital.

Thanks, William and Onward. I have some questions related to the World of Warcraft. As the contract between The9 and Blizzard is going to end early June, I'm sure you guys have already started some preparation for the operation of the World of Warcraft.

So can you give some color on how the preparation goes and how the preparation will impact on your cost and expense in the second quarter and the third quarter? (Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese)

(Spoken in Chinese)

Okay, maybe I'll just give a quick recap on William's answer. Basically, for the preparation work for these transitions, basically all the server and equipment has already been in place. And of course, we will always -- because of the volume that we are doing so far, of course those equipment would be -- are being purchased on a very cost effective basis. And so far, we are now in this stage of doing the installations and set up of all those equipment. And given that both Blizzard and NetEase are very capable and strong operators in the online game arenas and so we don't experience any problems so far in setting up those servers or equipments.

And with regard to the potential cost impact of those preparations, of course, this would be updated in the upcoming earnings. And so far, I think we are working closely with our partners on managing all the costs involved.

Okay. So in Q2, do you expect some additional expense in terms of hiring staff and technical (inaudible) and all those things? Should we model some additional spending in the Q2 P&L? (Spoken in Chinese).

Of course, in order to ensure the transition of taking up the World of Warcraft, there are a couple of costs that we need to spend on including the people hiring cost that you have just mentioned and the office rentals and also the server procurements. And of course all those costs would need to be accounted for hopefully in the second quarter.

Thank you. And that does conclude our question and answer session. I would now like to turn the call back over to management for any closing remarks.

Thank you once again for joining us today. Please feel free to contacts us if you have further questions and have a great day.

Ladies and gentlemen, this concludes the NetEase first quarter 2009 earnings conference call. We thank you for your participation and you may now disconnect.