NetEase Inc (NTES) 2009 Q3 法說會逐字稿

Ladies and gentlemen, welcome to the NetEase third quarter 2009 earnings conference call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question and answer session. (Operator Instructions). As a reminder, this conference is being recorded today, Wednesday, November 18, 2009.

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

Thank you operator. Please note 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 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 third quarter of 2009 increased to $128.8m, compared to $127.8m in the prior quarter and $118.2m in the third quarter of 2008.

Revenues for our online game business totaled $113.6m for the third quarter, compared to $114.5m in the second quarter and $98.9m for the third quarter of 2008.

An outstanding performance highlight for the quarter was Fantasy Westward Journey's record peak concurrent users of 2.5m on August 2, up from PCU numbers of 1.7m in the second quarter and compared to our previous PCU record of 2.3m achieved in August of last year. Daily ACUs were 575,000, compared with the same number in the second quarter. And new registered users increased 5% quarter-over-quarter.

Fantasy Westward Journey's record performance is a clear testament to the ongoing popularity and longevity of this iconic game. We believe that the longstanding success of Fantasy Westward Journey and our other leading self-developed games is due to our strong and talented research and development team, who continually provide superior gaming experiences to the growing dynamic user community in China.

We increased the size of our R&D team by approximately 10% during the third quarter, to 1,100 game developers.

PCUs and ACUs for Westward Journey II were 547,000 and 199,000 in the third quarter, respectively, compared with 591,000 and 207,000 in the second quarter, respectively. The newest expansion pack for this game, Tian Gong Kai Wu was released in August.

On September 19, 2009, our affiliated company, Shanghai EaseNet commenced the commercial operations in China of World of Warcraft, a game licensed from Blizzard Entertainment, after receiving the necessary approvals from appropriate government authorities. We are pleased to report that the World of Warcraft player response has been huge.

As we have previously disclosed, there is some regulatory uncertainty regarding World of Warcraft, following an announcement by the PRC General Administration of Press and Publications. We are currently seeking clarifications from the relevant governmental authorities regarding this statement by GAPP and look forward to a speedy resolution from the government authorities.

We have submitted the applications for Wrath of the Lich King to the relevant government authorities for review and approval. And we hope to be in a better positions to discuss the timing for Wrath of the Lich King in due course.

In September, we conducted a month-long marketing and sales campaign for the much anticipated open-beta launch of Tianxia II. The open-beta results met our targets in terms of both the number of players and paid users. And we are optimistic about the future growth of this game.

For the current quarter, we will release four expansion packs for Legend of Westward Journey, Tianxia II, New Fly for Fun and TF Online. In our new game pipeline, we started closed beta-testing of Ghost on August 7, and continued to make some improvements based on player feedback. We expect to commercialize this item-based game in mid 2010. This is another much anticipated 3D online game which is based on Liao-chai chih-I, the famous collections of classic China ghost stories. With the beautiful music and vivid scene settings, as well as rigorous fighting modes in the game, players can experience life and death, love and anger, as well as revenge and other emotions in the human world, heaven and hell.

We also started limited closed beta testing of Legend of Datang in the third quarter of 2009. At present, we are making improvement to the game design. We expect to commercialize this game in mid 2010 as well.

We have two self-developed item-based [WAP] games planned for launch before year end. These titles are [World of Sanguo], which was commercialized in early August of this year, and [Storm of Empires], which is expected to be commercialized in the fourth quarter of 2009.

We are excited about each of the new games in our development pipeline, which we believe will further diversify our user-base and enhance the popularity of our game portfolio.

Now turning to the advertising business. Revenues from the advertising services were $12.6m for the third quarter of 2009, compared to $10.7m and $16.6m for the preceding quarter and the third quarter of 2008, respectively. Our recent consolidation of [various] portal operations in Beijing, as well as other new marketing strategies launched in the beginning of the year began to deliver promising results.

We believe the consolidations of our sales, content and portal business-related marketing functions are best managed and streamlined in our Beijing office. The primary objective is to facilitate closer communications and coordinations between these functions and bring about improved content and marketing support with the overall goal of attracting new advertisers and keep longstanding relationships with existing ones.

Following the consolidations, we have strengthened our market competitiveness, resulting in a steady growth in both the number of advertisers and sales revenues. In terms of total revenues, the top-three performing vertical sectors for the third quarter were automobiles, Internet services and communications services.

Although short term macroeconomic data is uncertain, we have undoubtedly achieved an upward trend in our advertising business. And we remain cautiously optimistic about the course of improving advertising sales through the remainder of 2009 and into 2010.

That concludes William's remarks on games, advertising and portal. Now I will provide a review of our third 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 net profit.

Gross profit for the third quarter of 2009 was $91.9m, compared to $101.4m and $92.5m for the second quarter of 2009 and third quarter of 2008, respectively. The quarter-over-quarter decrease in gross profit was primarily attributable to the additional cost of revenues incurred for the ramp-up and operations of the licensed game, World of Warcraft, mainly comprising of server depreciation charges, custody fees and royalties, which was partially offset by increased advertising revenues in the third quarter of 2009.

The year-over-year decrease in gross profit was primarily attributable to the significant increase in cost of revenues incurred for the ramp-up and operations of World of Warcraft and decreased advertising revenue, partially offset by increased game revenue in the third quarter of 2009. Lower advertising revenue was reported for the third quarter of 2009 as the 2008 Olympic-effect ceased. Higher game revenue was reported for the third quarter of 2009, mainly due to the continued popularity of our self-developed games during the summer holidays, as well as the commercializations of World of Warcraft on September 19.

Gross profit margin for the online game business for the third quarter of 2009 was 79.9%, compared to 88.3% and 89.7% for the preceding quarter and the third quarter of 2008, respectively. The quarter-over-quarter and year-over-year decreases in gross profit margins were primarily attributable to the additional cost of revenues incurred for the ramp-up and operations of World of Warcraft in the third quarter of 2009.

Gross profit margins for the advertising business for the third quarter of 2009 was 23.1%, compared to gross profit margins of 16.6% and 26.9% for the preceding quarter and the third quarter of 2008, respectively. The quarter-over-quarter increase in gross profit margins was mainly attributable to the sequential increase in revenue during the third quarter of 2009. The year-over-year decrease in gross profit margin was mainly attributable to the decrease in revenue in the third quarter of 2009 as the 2008 Olympic-effect ceased.

Gross loss margins for the wireless value-added services and others business for the third quarter of 2009 was 45%, compared to 43% for the preceding quarter and 6.4% for the third quarter of 2008. The quarter-over-quarter and year-over-year increases in gross loss margins were mainly due to increased bandwidth and server custody fees resulting from increased traffic for email and photo blog services, as well as increased staff-related costs resulting from increased headcount in the third quarter of 2009.

Total operating expenses for the third quarter of 2009 were $32.1m, compared to $25.6m and $24.1m for the preceding quarter and the third quarter of 2008, respectively. The quarter-over-quarter and year-over-year increases in operating expenses were mainly due to the nationwide promotional activities conducted for many of our self-developed games during the summer holiday seasons and the re-launch of World of Warcraft in September 2009, along with increased advertising media and exhibition costs to promote the portal business during the third quarter of 2009.

We also recorded quarter-over-quarter and year-over-year increases in research and development costs during the third quarter, mainly resulting from increased headcount and increased server custody fees and bandwidth charges related to our research and development activities.

Net profit for the third quarter of 2009 was $57.7m, compared to $68.6m and $45.9m for the preceding quarter and the third quarter of 2008, respectively.

During the third quarter, we reported a net foreign exchange gain of $3.7m under other, net, compared to $6.9m for the preceding quarter and a net foreign exchange loss of $10m for the third quarter of 2008.

The quarter-over-quarter and year-over-year changes in foreign exchange gains and losses were mainly due to the translation gains or losses arising from the Company's euro-denominated bank deposit balances as of September 30, 2009, as the exchange rate of the euro against CNY fluctuated over the periods.

We reported basic and diluted earnings per American depositary share, or ADS of $0.45 and $0.44, respectively, for the third quarter of 2009. This compares to basic and diluted earnings per ADS of $0.53 each for the preceding quarter, and $0.36 and $0.35, respectively, for the third quarter of 2008.

We recorded an income tax charge of $9.6m, $16.9m and $18.4m for the third quarter, the preceding quarter, and the third quarter of 2008, respectively. The effective tax rate for the third quarter of 2009 was 14.3%, as compared to 19.8% and 28.6% for the preceding quarter and the third quarter of 2008, respectively.

The quarter-over-quarter decrease in tax charge was primarily due to the payment of an extra tax charge of $5.6m recorded in June 2009, related to the tax assessments of 2008 and the first quarter of 2009 by one of our subsidiaries. The year-over-year decrease in tax charge was primarily due to the applications of the statutory tax rate of 25% on the income of the subsidiaries in the third quarter of 2008, as approval for the preferred tax status of High and New Technology Enterprises was not received until December 2008.

Cash flows generated from operating activities totaled $39.5m for the third quarter of 2009, compared to $79.7m and $72.6m for the preceding quarter and the third quarter of 2008, respectively. In additions, the Company had a restricted cash balance of $12m.

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

As of September 30, 2009, cash and time deposits totaled $939.1m, compared to $822.3m as of December 31, 2008.

On September 12, 2008, the Company's Board authorized a share repurchase program of up to $100m of the Company's outstanding ADS for a period not to exceed one year. As of September 11, 2009 when the share repurchase program ended, we had spent in aggregate a total purchase considerations of approximately $13.1m, including transaction costs.

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

Thank you. And ladies and gentlemen, we will now begin the question and answer session. (Operator Instructions).

And our first question comes from the line of Richard Ji. Go ahead, please.

Hi William, Onward. Good morning and thank you for taking my call. I have two questions.

First, let me start with World of Warcraft. And this is obviously the key focus for our investor. And can you share with us any incremental development on the regulatory front, and given this is a big [overhead].

And secondly, can you also give us some color on the performance metrics for World of Warcraft after commercialization?

(Spoken in Chinese).

To answer Richard's questions on the World of Warcraft, regarding the regulatory developments, from the Company's point of view, we would always follow the prevailing rules and regulations in doing the relevant and appropriate applications and approvals, and to make sure that we would be in compliance in making sure that our operations or the launch of the product or the game itself should be fine.

And regarding the performance metrics, by now, since the launch of the games, from the Company's perspective, we are quite satisfied with this performance so far.

Thank you, William, Onward. And let me ask another question. And clearly you have a very deep self-developed pipeline. Especially Tianxia II has recently turned into a blockbuster. And can you share with us in some of the performance metrics, as well as the outlook and your expectation for Tianxia II, going forward?

And also, among your new games -- and which one and -- would you expect that may have a chance to turn into a new blockbuster? Thank you.

Thank you, Richard.

(Spoken in Chinese).

Richard, regarding your first questions about the performance of Tianxia II, so far the Company's view is that our -- the market performance is quite -- we are quite satisfied with this market performance.

And with regarding the Company's strategies or the visions going forward to further develop this game, we will continue to add in more new content and new gameplays to attract the players. Also, both the management and also the game developers are also setting very high expectations in making sure that through the various efforts in bringing up the operations of this game, we aim to make this game to be one of the most popular 3D MMORPG game in the China markets.

And regarding our new game partner developments, I think towards the end of 2009 or in up to early 2010, what we are currently doing, we will still continue to proceed on and say for example, the (inaudible) of our new games are still under the testing phase. And we will still proceed to move on making sure that it would be another new and popular game to the market.

Thank you. (Spoken in Chinese).

Thank you, and our next question comes from the line of Wallace Cheung. Go ahead please.

Good morning, William and Onward. Just quickly on the cost side, can you give us a bit more color in terms of the cost of goods sold, as well as the operating expenses? How much [of that is] contributed from the World of Warcraft? Thank you.

I think by -- for the third quarter, basically, we have launched the games since September 19 and we are already taking in the revenues of this game. And for the cost of this game, I think by now, it will include the IDC cost, the server depreciation charges and the royalties and such that we have already allocated and discussed in the release. And I think this would also be the profile that we will continue to move on going forward.

And another question regarding the wireless and other subscription business, we have seen both the revenue line and cost of goods sold line actually increase and also expansion like the server -- the cost for the email service increased. Have you seen any indication in the user level on the email service increasing and the potential monetization of the email is actually improving as well?

Thank you.

We believe so because we are continuing -- this is a continued effort for us to develop our existing email services. And from time to time, we will also try to build up our server facilities to cope with the demand or the usage of our users. And so we are still quite satisfied with its performance right now.

How much of the revenue in this line is coming from the email related services?

In terms of the email services, I think -- just a moment. (Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese).

Okay. (Spoken in Chinese).

Thank you.

Thank you, and our next question comes from the line of Dick Wei, go ahead please.

Hi, good morning. Thanks for taking my questions.

My question is -- the first one is for the pipeline in 2010, can you talk about like which one or two will be kind of the key games that have the highest expectations by the Company?

(Spoken in Chinese).

(Spoken in Chinese).

To recap for what William has commented on just now, basically, the Company will take a very serious approach in for whatever new games being developed. And for all the new games that are due to go out to the market in the upcoming years, for each of those games, we also have high expectations of them. And we believe that they would also perform well because there would be various kinds of games that we'll put up in the market including 2D and 3Ds and different game types including those like the role playing games and some other casual games and things like that.

Great. Just two more questions on the financial side. The first one is on the cash flow statement, the prepayment and other current assets about the CNY248m, is that mainly related to some payment to Blizzard?

Correct.

On the cash flow statement. Okay. And then as far as the deferred revenue is concerned, I think there's a Q-over-Q increase. Was it mainly due -- I don't know if you'll be able to comment how much has come from the typical higher seasonality (inaudible) and how much is from the Warcraft.

I think basically, the increase in our deferred revenues for the third quarter were -- mainly come from two areas. One of those would be from the launch of the World of Warcraft where the players would also buy more points to play the games and the other parts would definitely - comes to the fact that in anticipation of the coming national holidays and the distributors would usually -- are buying more point cards to meet the demand during the national holidays.

Okay. Great. Thanks a lot.

Thank you, and our next question comes from the line of Alicia Yap, go ahead please.

Hi, good morning William and Onward. I have two questions.

First of all, can you comment on the competitive dynamics for the 2D [turn] based games as there have been some newly launched 2D games in the market. Have you see any impact especially to your Fantasy Westward Journey? If so, what will be your strategy to defend your market leading position?

(Spoken in Chinese).

Okay. Basically, from the macro view, we believe that the whole industry is getting more and more competition and the competition is getting more intense. And the expectations from the players are also higher and higher. But having said that, whether the game itself is 2D or 3D is not that important. What is more important is how well we could really deliver in the games because we always believe that even for the 2D games, we can also do it in a very nice manner by having a very good game play and very good content therein in order to attract the players and to making sure that they would continue their interest to play the games.

And so this would -- is just a matter to prove that it would continue to be a success.

Okay, thank you. My second question is regarding the advertising business. So have you seen meaningful uptick from the demand environment after the Golden Week holidays? And particularly, which sector has the most potential to experience highest growth in the fourth quarter and into 2010?

I think basically, for the advertising business, we have seen that for 2009, it has been a very challenging year. And in the past three quarters, we have seen that the development has been progressing well and especially you will see that in both the second quarter and the third quarters, there has been an increase or a growth in terms of our advertising revenues. And so far, from what the Company's observed and recorded, we believe that the top three vertical industries would be the automobile, the Internet services and also the communication services industries.

So that was the three category in the third quarter. Would that be similar for the fourth quarter in 2010 in your expectations?

I think for the quarters going forward, I think at this stage we wouldn't be able to give you a very concrete answer. But basically, from what we have seen so far, we still see those industry verticals would still have a good room to develop.

Okay, thank you so much.

Thank you, and our next question comes from the line of Ming Zhao. Go ahead please.

Thanks for taking my question. Just two quick number questions,

Onward, can you tell us if you have recognized any deferred revenue from those dormant accounts this quarter? And the second question is if we look at sales and marketing expense, how much of that was due to launching Tianxia II and how much of that is due to World of Warcraft? And how should we look at this line in the fourth quarter? Those are my questions. Thank you.

Sorry, Ming. For the first questions, regarding the deferred revenue, can you repeat again what exactly that you would like to ask?

Yes, sure. I think last quarter, you recognized $12m of --

For the dormant accounts? You mean the dormant accounts?

Yes, how much did you do this quarter?

I think the Company wouldn't disclose this number for this quarter because for the second quarter, this would be our first time doing the clean-up for those dormant accounts and in view of the fact that the dollar amount is relatively more material and significant and so we will give you a sense. But what we can share with you is that for this quarter, the amount of deferred revenues coming from those dormant accounts wouldn't be that bad.

Okay and then the second question about the sales and marketing expense. How much of that is due to World of Warcraft and how much is due to Tianxia II and is there a significant reduction in the fourth quarter?

Maybe I will just answer you from different angles. For the third quarter, the selling and marketing expenses, the increase would mainly be coming through two areas. One would be on our existing developed games, on our various game titles because starting from the third quarter, we have started to carry out more marketing and promotional activities for various of our game titles.

And the other area that we have increased our marketing and selling expenses is that we have also do more brand activities to promote the Company's brand names and things like that. And for the third quarter, I think the contribution with regard of the World of Warcraft wouldn't be that significant owing to the fact that you would realize that we only just launched the games on September 19.

But going forward, we would still believe that the Company would continue to put in more efforts in doing the selling and marketing activities.

Great. Thank you.

Thank you, and our next question comes from the line of Gary Ngan. Go ahead please.

Good morning, William and Onward. Thank you very much for taking my question.

I have a couple of questions. Firstly, on the increase in cost of revenues in Q3, as you mentioned, most of that is the increases from depreciation and amortization largely, so if I look at it -- depreciation increased by CNY22m while the cost of revenues increased by CNY63m so the difference is CNY40m. So what exactly is in that CNY40m and how much of that is staff cost? Can you give us a [percentage] breakdown?

I think we wouldn't give out a further breakdown. But basically, you are right that the increase in the cost of revenue would be mainly comprised of the server depreciation charges for this quarter and also, the custody fees and royalties and things like that.

Okay, thank you.

So my next question is because Shanghai EaseNet is an affiliate of the Company and I actually don't really see that line being captured in the financial statement, can you tell us where exactly it would be put?

I think basically, because this is one of our affiliate companies and just as what we have [catered] for our other companies in our Group, this would be considered on a consolidated basis. And so there wouldn't be any separate lines that we are going to show.

Okay. So would I be correct to assume that actually, the 50% joint venture profit that goes to your partner actually would be captured in the minority line?

I think we wouldn't make further comments on this kind of question. Sorry for that.

Thanks. My final question, it's that the Ministry of Culture announced a new rule on the games regulation and particularly, they said they will have to make a more stringent control on the PK system, [webbing] system, and also the leveling mode of the games so what do you think the impact would be to our games now? (Spoken in Chinese).

(Spoken in Chinese).

(Spoken in Chinese).

Just one second, maybe we can translate that.

Sure. I think basically, the Company would like to reiterate that at all times, for a online game companies in China, what we would have done would be in full compliance with the relevant rules and regulations. And this is what we always have been doing and would be doing going forward.

Thank you, and our next question comes from the line of Kathy Chen. Go ahead please.

Hi, thanks for taking my question.

I just have one question regarding the Fantasy Westward Journey and Westward Journey II trends during the quarter. It looks like the Fantasy Westward Journey ACU was flat quarter-on-quarter and down by about 15% year-on-year while the Westward Journey II ACU is down about 4% quarter-on-quarter.

Can you explain the weakness and the quarterly trends given that I think third quarter is usually a seasonally stronger quarter for you? Are you seeing these games reaching a more mature stage or is this due to a higher competition from some new games during the quarter? Thanks.

Thank you for your questions, Kathy.

I think basically, for the third quarter traditionally this would be our highest seasons because of the summer holidays. Even though from the ACU numbers that you have just mentioned doing some sort of the comparison, but we still see that the overall performance of the games itself is quite good and especially through our launch of some promotional activities and the launch of some expansion packs to the games. And at all times, we don't believe that these games itself has come to a mature point because from time to time, we would always launch out some new expansion packs to enrich the contents inside the games and also to enrich the game play and the features of the games in order to making sure that the interest of the players can sustain and would sustain -- continue to play the games with us.

Thanks. If I could just add a follow up. Could you remind us whether there was an expansion pack launched for both games in the third quarter and whether there will be any expansion packs to be launched in the fourth quarter?

If you are talking about the launch of the expansion packs for the Fantasy Westward Journey, in fact, we have already launched another new one on the -- in mid-October, whereas for the Westward Journey II, we have already launched another new expansion pack in mid-August this year.

Okay, thank you.

Thank you, our next question comes from the line of Eddie Leung. Go ahead please.

Good morning, just one question. Is there any plans to increase item selling in the two old blockbusters, WWII and Fantasy Westward Journey? Thank you.

(Spoken in Chinese).

Right now, we don't have any plan of doing the item selling in our existing [time-based] games mainly for the Fantasy Westward Journey or the Westward Journey II.

Got that. Thank you.

Okay.

Thank you and ladies and gentlemen, that does conclude our question and answer session for this conference. I would now like to turn the conference back over to management for any closing statements.

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

And ladies and gentlemen, this concludes the NetEase third quarter 2009 earnings conference call. If you like to listen to a replay of today's conference, please dial 1-800-406-7325 or 303-590-3030 with the passcode 417-5189.

Thank you and you may now disconnect.