NetEase Inc (NTES) 2010 Q1 法說會逐字稿

Good evening ladies and gentlemen and welcome to the NetEase first quarter 2010 earnings conference call. (Operator Instructions). As a reminder, this conference is being recorded Wednesday, May 19, 2010. I would now like to turn the conference over to Brandi Piacente, Investor Relations. Please go ahead.

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. Before I begin, please note that for the purposes of this discussion, all percentages are based on renminbi.

For the first quarter of 2010, total revenues increased 52.9% year-over-year to CNY1.2b or $175.1m. Revenues from Online Games increased 49.9% year-over-year to CNY1.1b or $139m and revenues from Advertising Services increased 123.1% year-over-year to CNY91.5m or $13.4m. Our quarterly net profit increased 7.9% year-over-year to CNY452.3m or $66.3m, with basic and diluted earnings per ADS of $0.51.

On a sequential basis, total revenues decreased 7.4%. Revenues from Online Games decreased just slightly by 0.3% and revenues from advertising services decreased 50.2%. Net profit decreased 21.4% quarter-over-quarter from CNY571.8m for the fourth quarter of 2009. Net profit for the first quarter included a net foreign exchange loss of CNY39.5m or $5.8m.

In Online Games, the first quarter brought favorable outcomes from recently launched game expansion packs. Ancient Runes, the ninth expansion pack for Fantasy Westward Journey launched in October 2009 delivered favorable feedback from players as reflected in the new player statistics during the first quarter of 2010 as compared with the previous quarter.

For Westward Journey II and III we plan to launch two additional expansion packs during the third quarter of 2010, reflecting our continuing effort to update content and promote new user interest for these games.

Tianxia II delivered strong growth in new player statistics for the first quarter following the December 2009 launch of its Flying Dragon expansion pack. We plan to issue another new expansion pack to coincide with the first anniversary of Tianxia II in September 2010, along with a series of sales promotion activities to drive further growth for this game.

We commercially launched our in-house developed 2.5G martial arts MMORPG Heroes of Tang Dynasty in April 2010 following successful closed beta testing results and plan to launch an expansion pack for this game in the fourth quarter of 2010.

World of Warcraft, a game licensed from Blizzard Entertainment delivered strong performance during the first quarter and we are currently testing ways to expand the game's presence in certain second and third tier cities in China. Our application for the launch of Wrath of the Lich King, the game's second expansion set is currently under regulatory review.

It's important to note that our strong year-over-year Online Games revenue growth of 49.9% was primarily due to revenues generated from new games and the operations of Blizzard Entertainment's World of Warcraft.

Now turning to portal activity, we recorded steady traffic growth during the first quarter especially within the newly introduced content channels. Expo, Asian Games, travel and education all showed high growth in traffic. Our portal also achieved the largest quarterly increase in new email accounts in over a year to more than 325m users as of March 31, 2010.

In Advertising we continue to benefit from the brand advertising recovery in the first quarter. Our strong revenue growth year-over-year reflected this rebound in the Chinese advertising market driven by overall improvement at the macroeconomic level which in turn triggered an easing of advertising budgets by customers.

The quarter-over-quarter decline in Advertising revenue of approximately 50% from our strong fourth quarter 2009 revenue result reflects the typical first quarter seasonality for the industry. Our best performing Advertising sectors in the first quarter of 2010 were automobile, internet services and apparel, the same as last quarter and a trend that we expect may continue the rest of this year.

We believe our strong year-over-year improvement in Advertising sales also demonstrates the successful execution of our advertising and portal development strategies and our delivery of new value-added services to advertisers since the year-ago period.

This concludes William's remarks on games, advertising and portal. Now I will provide a review of our first quarter 2010 financial results. 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 first quarter of 2010 was CNY780.7m or $114.4m, compared to CNY844.1m and CNY641.7m for the fourth quarter of 2009 and the first quarter of 2009, respectively. The quarter-over-quarter decrease in gross profit was primarily attributable to a seasonal decline in Advertising revenue. The year-over-year increase in gross profit was primarily attributable to increased Online Games revenue, mainly from World of Warcraft operations, and increased Advertising revenue, mainly attributed to the rebound in the Chinese advertising market and the successful executions of our advertising and portal development strategies in the first quarter of 2010.

The foregoing revenue increases were partially offset by increased cost of revenues, mainly attributable to royalties and consultancy fees related to World of Warcraft operations, headcount-related staffing costs for both the Online Games and Advertising businesses and increased content costs in the first quarter of 2010.

Gross profit margin for the Online Game business for the first quarter of 2010 was 72.1%, compared to 70.8% and 90% for the preceding quarter and the first quarter of 2009, respectively. The slight quarter-over-quarter improvement in gross profit margin was due to the change of product mix in the first quarter of 2010. The year-over-year decrease in gross profit margin was primarily due to World of Warcraft operations in the current quarter. Lower margin for World of Warcraft operations compared to in-house developed games is primarily because of royalties, amortization of license fees and technical consultancy service fees associated with the licensing and operations of Blizzard Entertainment's World of Warcraft.

Gross profit margin for the Advertising business for the first quarter of 2010 was 22.9%, compared to gross profit margin of 58.4% for the preceding quarter and gross loss margin of 13.1% for the first quarter of 2009, respectively. The quarter-over-quarter decrease in gross profit margin was primarily due to the significant seasonal decrease in Advertising revenues which was partially offset by relatively small reductions in related costs of revenue. The year-over-year increase in gross profit margin was primarily due to the significant year-over-year increase in Advertising revenue.

Gross loss margin for the Wireless Value-Added Services and Others business for the first quarter of 2010 was 34%, compared to 38.5% for the preceding quarter and 22.3% for the first quarter of 2009.

The quarter-over-quarter decrease in gross loss margin was mainly due to reduced depreciation charge as servers associated with Wireless Value-Added Services operations became fully depreciated and reduced other miscellaneous cost of revenues in the current quarter. The year-over-year increase in gross loss margin was mainly due to increased server custody usage fees in the current quarter resulting from volume increases associated with our free email and photo blog services and higher headcount-related costs, partially offset by reduced depreciation charge in the current quarter as assets became fully depreciated.

Total operating expenses for the first quarter of 2010 were CNY225.7m or $33.1m, compared to CNY237m and CNY150.6m for the preceding quarter and the first quarter of 2009, respectively. The quarter-over-quarter decrease was mainly due to reduced marketing spending on corporate brand-building and promotional activities in the current quarter and decreased headcount-related staffing costs. The year-over-year increase was primarily due to the significant increases in advertising spending on corporate-brand building and marketing promotions of Fantasy Westward Journey and Blizzard Entertainment's World of Warcraft, and increased headcount-related staffing costs in the sales and marketing and research and development areas.

Net profit for the first quarter of 2010 was CNY452.3m or $66.3m, compared to CNY571.8m and CNY416.7m for the preceding quarter and the first quarter of 2009, respectively.

During the first quarter we reported a net foreign exchange loss of CNY39.5m or $5.8m under Other net, compared to CNY15.3m and CNY47.5m for the preceding quarter and the first quarter of 2009, respectively. The quarter-over-quarter and year-over-year changes in foreign exchange losses were mainly due to the translation losses arising from our euro-denominated bank deposit balances as of March 31, 2010 as the exchange rate of the euro against the CNY fluctuated over the periods.

We reported basic and diluted earnings per ADS of $0.51 each for the first quarter of 2010. This compares to basic and diluted earnings per ADS of $0.65 and $0.64 for the preceding quarter and $0.68 (sic - see press release) and $0.47 for the first quarter of 2009, respectively.

We recorded a net income tax charge of CNY94.5m or $13.8m for the first quarter of 2010, compared with CNY71.2m and CNY61.7m for the preceding quarter and the first quarter of 2009, respectively. The effective tax rate for the first quarter of 2010 was 17.4% as compared to 11.3% and 12.9% for the preceding quarter and the first quarter of 2009, respectively.

The quarter-over-quarter increase in effective tax rate was mainly due to the reduction in income tax charge of certain subsidiaries for the first three quarters of 2009 recorded in the fourth quarter of 2009, reflecting qualification for preferred tax status being received in December 2009. The year-over-year increase in the effective tax rate was primarily due to the fact that one of the Company's principal subsidiaries reported its tax charge at the rate of 7.5% in the first quarter of 2009 as well as the fact that the net income derived from World of Warcraft operations is subject to the standard enterprise income tax rate of 25% in China in the first quarter of 2010.

Cash flow generated from operating activities was CNY676.5m or $99.1m for the first quarter of 2010, compared to CNY712.4m and CNY567.8m for the preceding quarter and the first quarter of 2009, respectively.

As of March 31, 2010, our total cash and time deposit balance was CNY7.7b or $1.1b, compared to CNY7b as of December 31, 2009. In addition, the restricted cash balance was CNY32m as of March 31, 2010, representing a security guarantee for consulting fee payments due to Blizzard Entertainment for a 12-month period to October 2010. The guarantee will be renewable annually until termination of the license agreement for the operations of World of Warcraft.

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

Thank you. Ladies and gentlemen, at this time we will now begin the question and answer session. (Operator Instructions). Our first question comes from the line of Richard Ji with Morgan Stanley. Please go ahead.

Thank you William and Onward, and good morning. I have two questions. Let me first start with Fantasy Westward Journey which is your legacy flagship game. Have we seen a sign of stabilization in the recent months and also going forward, should we expect a reacceleration for Fantasy Westward Journey?

(Spoken in foreign language).

With regard to William's remarks, first of all in the past one year, the Company has undertake various and lots of measures in order to design ways to further enhance and improve the current ways of playing the games, mainly the Fantasy Westward Journey. All of these measures aims to further bring up the attractions to our existing gamers and hopefully potential gamers to our games which we believe would got the interest and support from the players.

And in terms of the timeframe, we expect that hopefully in July, somewhere around the summer holidays this year, all of this new stuff would come up. And together with this launch of or the implementations of some new game plays and features to the game, we would also put into sales and promotional campaigns to bring together all these kind of efforts.

Thank you William and Onward. And my follow-up question is regarding your new game pipeline, especially Tianxia II, what is the ARPU trend over the recent months? And also for your new hit, Heroes of Tang Dynasty, can you elaborate a little more on the feedback from the gamers, after the initial launch stage?

(Spoken in foreign language).

Okay, let me summarize what William has just highlighted. First of all, regarding the ARPU trend in recent months relating to the Tianxia II, it's roughly about [CNY100] per month.

With regard to the second product, the Heroes of Tang Dynasty, since our launch of the unlimited closed beta testing on April 16, the feedback from the gamers has been very satisfactory, which proves that they are very satisfied and happy with our product quality.

And there is one more thing that William has added regarding the launch of the unlimited closed beta testing for the Ghost, which we target would happen in mid of July this year.

Thank you.

Our next question comes from the line of Dick Wei with JP Morgan. Please go ahead.

Hi, morning. Thanks for taking my questions. The first question is that is it possible to rank the top five games for NetEase this quarter by revenue or by ACUs, some other operating metrics. Thanks.

(Interpreted). I think, Dick, I think at the moment because we have quite a lot of products being launched in the market, it's not that easy and representative to give out any ranking in this sense because different products would have different features. And so I think right now it wouldn't be able to give you a very clear sense. But perhaps you can make reference to the previous trend to get sort of a reference point.

Okay. And second question is on Heroes of Dy. Tang, what kind of user metrics that you're seeing at the current situation, after the unlimited closed beta testing?

(Interpreted). In short I think at the moment I think we wouldn't give out any ACU or PCU numbers with regard to the performance of the Heroes of Tang Dynasty. But having said so, so far the feedback has been very satisfying -- we are very satisfactory. And also the feedback has been quite exceeded our original expectations.

Thank you [sesei] William.

Thank you. Our next question comes from the line of Alicia Yap with Citigroup. Please go ahead.

Hi. Good morning William and Onward. I have three questions. First of all in your prepared remarks you mentioned that you're testing the ways to expand World of Warcraft to the second and third tier cities. Any color on the progress that you can share with us and how much more upside do you think the second and third tier cities could bring to the game? This is the first question.

(Interpreted). Basically we are still undertake various measures to push the products to the second and third tier cities in China and we believe we will get some good progress going forward.

And second question is with the global launch date for Starcraft II set for July 27, is there any color you could share with us regarding the timeline for China launch?

And have you started to work on the localization of the game?

(Interpreted). Okay, with regard to the timeline of the launch of the Starcraft in China, I think basically there would be a few things that we need to do. First we need to discuss with our cooperation partners Blizzard to see how it goes. And at the same time, before the launch of the games we still need to go through the regulatory review by the relevant government authorities. And basically at this stage, when it comes to the times that we're going to launch the games, then we hopefully would give out another announcement to that.

Thank you. And then lastly there have been a lot of concerns lately on the overall online gaming industry and investors worry about the prospects for the sector going forward. Could you share with us your view on the industry growth going forward?

(Interpreted). Basically, with regard to the growth trend relating to the overall online gaming industry, we still hold a positive view about its growth trend. For all the companies in this industry I think there will be a few things that we consider would be critical and very important to succeed. First, whether or not they have very good products and whether their product can get the acceptance and satisfactions from the gamers. If those criteria can be met, then definitely there will be room for those products to gain success in the market.

And for NetEase itself we still strongly believe that we've got the competence, capabilities and patience to do the best effort products in the products to make sure that we will excel in this part of the business and the industry.

Thank you very much [sesei] William.

Thank you. Our next question comes from Wallace Cheung with Credit Suisse. Please go ahead.

Hi. Good morning William, Onward and Brandi. Two questions. One is on the recent talents turnover of the overall gaming industry. I think a lot of like venture capitalist or other competitors have been hiring competitors' talents, R&D talents of the gaming industry. So any specific strategy that you can implement to try to maintain the talents and even attract more talents going forward?

The second question will be on the search strategy. Given that NetEase have been putting a lot of effort on your Youdao and also Google is exiting from the China market, how do you see the search strategy going forward, try to take more market share in terms of R&D and also in terms of the revenue? Thank you.

(Interpreted). Okay, Wallace, with regard to the first question relating to the turnover in the online gaming industry, I think the Company's management put a very strong view and focus to make sure that we have the best people to work with us no matter that they are the research and development people. And also all parts, including other functional areas people, because we believe that through this kind of focus to the developments of our people it can help us to develop some very good products that can excel in the market. And of course, in order to make this happen, we would make very big efforts in training up our staff as such.

And with regard to the second question, regarding the search strategy we still believe that currently the China market we've still got room to develop this part of the business because the search tools have progressively become indispensable to every people's life. And also the Company would be very willing to invest in this part of the business in order to further push up our business in this sector.

Alright, thank you. Just two quick follow ups. One is, so for my first question, we have seen that the R&D expenses as a percent of revenues actually on a rising trend. So do we expect that NetEase also actually still increasing your salary expenses on the R&D front as such to maintain the talent?

And the second question is because William mentioned about Company is going to invest further in the search engine. Does this involve into potentials of M&A on the search side? Thank you.

Okay. With regard to first question regarding the R&D expenses percentage I think this would be natural for the Company to increase by keeping the expansion plan with the Company. And from time to time we definitely would make sure that we invest sufficient amount in order to upkeep our R&D efforts in the business.

(Interpreted). Wallace, with regard to your second follow up question regarding whether or not the Company will undertake any M&A, I think the basic question is whether or not any potential M&A would bring some positive impacts to further develop our search business strategies.

(Spoken in foreign language).

Thank you. Our next question comes from Eddie Leung with Bank of America - Merrill Lynch. Please go ahead.

Good morning William, Onward and Brandi. My first question is about your seasonality. Could you share with us the potential seasonality on TX II and World of Warcraft into the second quarter?

(Interpreted). With regard to the seasonality on the two games that Eddie has just mentioned, namely the Tianxia II and World of Warcraft, I think basically the Company's management will still hold a positive view about growth trend going forward. And with regard in particular for the Tianxia II product, because this one has been developed by ourselves, we have been intensively doing more stuff such as to increase the functionalities and game plays in order to meet the demand and interest of our gamers for this game.

Just to follow up on this point. I understand that you guys have confidence on the long term trend. I'm asking for Tianxia II and World of Warcraft as hardcore MMO, are they going to be affected by school holidays or examinations?

(Spoken in foreign language).

I think basically I think it would not be a very appropriate timing for us to make any projections or expectations on how those games would be doing, especially in the upcoming summer holidays. But one point that William has shared with us is that we did observe, especially in the past, in this month the Labor holidays, we have three days holidays starting from May 1. And in particular the performance of Tianxia II has been very impressive. And I think this can somehow give you some insight on how this game would go.

Understood. And my next question is on your tax rate. Could you give us the full year tax rate expectations given the fluctuations early in the first quarter?

Just as what the Company has said in previous earnings, basically for 2010 for the overall effective tax rate we do still expect that it would happen in the range of 18% to 23%.

Got that. And my last question is on Heroes of Tang Dynasty. Given the nature of these games should we expect the ARPU level to be similar to Tianxia II when the game stabilizes?

(Interpreted). The ARPU numbers for the two games would be similar, namely Heroes of Tang Dynasty and Tianxia II, yes.

Thank you William and Onward.

Thank you. Our next question comes from the line of Ming Zhao with SIG. Please go ahead.

Thank you. Good morning. I have two questions. First on the, you have a lot of cash on your balance sheet. Could you share with us what's your plan for that? Do you have any M&A target or you have any share buyback or dividend payment planned?

(Interpreted). With regard to the utilization plan on the Company's cash, no matter, for the M&A if we can come up with a suitable target and with a suitable price, no matter it is related to search or not, then NetEase has always been holding a very open attitude to it and wouldn't be preclude this kind of opportunities.

With regard to the share buyback, again if we consider that the price is suitable then we also will do so. And in fact for the past few years NetEase has also undertake a few rounds of share buyback as such. And for the potential use, whether we would defer any dividends or not, at the moment we've got no such plans.

Okay, thank you. My next question is about the costs that we should expect on the portal side. You are going to be the sponsor of the Asian Games and maybe you have to plan to buy the World Cup video content, so any color there?

And maybe just a related question on the advertising. What's your advertising outlook for the second quarter and beyond.

(Interpreted). Ming, regard to the costs for the site, I think you are quite right that for this year there would be a few events that we are going to undertake, namely the Asian Games, the World Cup and also maybe the World Expo currently undertaking in the Shanghai. And of course through all these kind of games, the content procurements, we would make sure that we would procure the most premium contents to make sure that we can provide it to audiences of our portals as such.

Thank you.

(Interpreted). So with regard to the advertising outlook I think we still need to get in more information before we can comment on about the outlook going forward.

Okay.

Thank you. Our next question comes from the line of Kathy Chen with Goldman Sachs. Please go ahead.

Hi. Thanks for taking the question. I just have one question. I'd like to clarify the comment you made in your prepared remarks that gross margin was up quarter on quarter for the Gaming business due to the product mix. I think World of Warcraft should be up quarter on quarter up helped by less than usual credits from the previous game operator.

Sorry Kathy, your line is not very clear and we just can't hear you clearly.

Is this better?

It's better now.

Okay, sorry. So let me repeat my question. Basically my question is if you could clarify the comment during the prepared remarks that gross margin for the game business was up sequentially in the first quarter due to product mix. I think World of Warcraft should be up sequentially up by fewer residual credits from the prior game operator. And this is a lower margin game compared to your other games. So if you could just please clarify what kind of product mix just did you see in the first quarter on the quarter-on-quarter basis. Thanks.

I think basically still the product mix was mainly related to our game products, mainly our self-developed games and also the licensed games. And for the first quarter I think the main portion would still go to our self-developed games which have a high gross margins profile.

Okay. So basically is it reasonable to say that the self-developed games saw a faster sequential growth in the first quarter compared to World of Warcraft?

I think we would consider it from the entire revenue amount rather than just looking solely at the trend because we have got quite a lot of different products performing differently.

Maybe if I could just follow up on that then. What about for World of Warcraft is it reasonable to say that there was a sequential boost because I think fourth quarter also had some impact from The9 credits.

I think basically for the World of Warcraft you will need to take into account our sales promotional campaigns that have been undertaken in the first quarter, especially during the Chinese New Year. We have offered 21 hours free play to our players, to those players, and you would expect that there would be an impact to our revenue of World of Warcraft for the first quarter as such.

Right.

And of course you're quite right in saying that the previous credits being brought forward from the previous operator has already been consumed or digested in the previous quarter. And those impact wouldn't happen again in the first quarter and so you would still make note to the sales promotional campaigns for the first quarter.

Okay great. Thank you.

Thank you. Our final question comes from the line of Tian Hou with Auriga USA. Please go ahead.

Hi this is [Gina Chan] dialing in for Tian. I have two questions. The first one is with the Asian Games, the World Cup and the World Expo happening this year, do you expect these events to drive significant incremental upside to your advertising revenue?

I think basically, just to recap on the previous question, that is similar to the outlook of our view on the advertising in the upcoming quarters, we still need to get in more information before we can comment on it. And so as such I think we don't have much to share at this point of time.

Okay. And then can you just give us a brief update on the game pipeline and how many more games you plan to launch this year aside from what you've announced?

(Interpreted). With regard to the game pipeline, I think basically in mid of July the unlimited closed beta testing of Ghost would be launched. And hopefully in the second half of this year there would be another game with the farm theme that would be coming out.

But we would just like to reiterate the fact that our Company is not a very high focusing on a high volume of games being launched on to the market, but rather we would focus on delivering a very high quality products to the market, meeting different kind of interest and demand of the gamers in the market. And would suggest not to focus too much on how many games that we are going to launch for each year.

Okay great. Thanks.

Thanks.

This concludes the question and answer session. I would now like turn the call back over to management for any closing remarks.

Thank you again everyone for joining us today. Please feel free to contact us with further questions. Have a great day.

Ladies and gentlemen, this concludes the NetEase first quarter 2010 earnings conference call. If you'd like to listen to a replay of today's conference call please dial 1800 406 7325, put in code 4291513-pound. You may now disconnect.

Portions of this transcript that are noted "interpreted" were interpreted on the conference call by an Interpreter present on the live call. The interpreter was provided by the Company sponsoring this Event.