NetEase Inc (NTES) 2010 Q2 法說會逐字稿

(audio in progress)

Ladies and gentlemen, thank you for standing by and welcome to the NetEase second quarter 2010 earnings conference call. (Operator Instructions). This conference is being recorded today, August 18, 2010, and at this time I'd 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 harbour from liability as established by the US Private Securities Litigation Reform Act. Such statements are not guarantees for 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 in 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 call 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 second quarter of 2010, total revenues increased 54.4% year over year to RMB1.3 billion or $198.6 million. Revenues from Online Games increased 51.1% year over year to RMB1.2 billion or $174.1 million, driven by newer games and the operations of Blizzard Entertainment's World of Warcraft. Revenues from advertising services also showed impressive growth of 100.5% year over year to RMB145.9 million or $21.5 million.

Our quarterly net profit increased 3.8% year over year to RMB485.7 million or $71.6 million, with basic and diluted earnings per ADS of US0.55. On the sequential basis, total revenues increased 12.7%; revenues from Online Games increased 8.8%; and revenues from advertising services increased 59.4%. Net profit increased at 7.4% quarter over quarter and included a net foreign exchange loss of RMB57.8 million or $10 million. In Online Games we introduced a new product for Fantasy Westward Journey with known music artist Jay Chou, and held large scale marketing promotions over the summer.

We also rolling out a first-of-its-kind game design features in China for Fantasy Westward Journey players. It's a new dual scene setting known as Weimei version - meaning perfect beauty - that features 3D graphics and even cuter and more realistic appearance of the rogue characters. The next expansion pack for Fantasy Westward Journey is under development and is scheduled for release during the fourth quarter. We also remain on schedule to release new expansion packs for Westward Journey Online II and III during the third quarter.

On August 15 we hosted a big event for players to celebrate the eight anniversary of Westward Journey Online II in Beijing. Heroes of Tang Dynasty exceeded our expectations in the first two quarters and as a result we will advance the release of the next expansion pack to the third quarter. We have also signed a high profile spokesperson for this game product and we will launch a major sales promotion campaign later this year. Tianxia II also performed well during the second quarter, closing its effectual first year of commercial launch. This game held a nationwide promotional campaign for players in April. We will continue making strong promotional support for both Heroes of Tang Dynasty and Tianxia II and are planning large scale promotional campaigns for each of these games in the third quarter.

World of Warcraft, again licensed from Blizzard Entertainment, continued to perform well during the second quarter. We have now received the relevant government authority's approval for the operations of Wrath of the Lich King, the game's second expansion pack, and we'll start the commercial operations of the expansion as soon as we complete all necessary technical procedures. We have a series of promotional activities planned to coincide with the expansion's release to attract both new and returning players and we look forward to the successful launch of Wrath of the Lich King in China.

Now, turning to portal activity, our internet portal traffic grew significantly during the second quarter, mainly due to our comprehensive coverage of major events such as the 2010 FIFA World Cup and Expo 2010 in Shanghai. Our daily average (inaudible) increased by a strong double digit percentage quarter over quarter.

The strong growth in advertising services revenue for the second quarter was driven by a combination of factors including the domestic economic recovery, improved portal traffic during the second quarter, increasing commissions by advertisers of our user diversity, expansive range and thickness of our portal, and improved internal organisational structures resulting in more effective marketing and self-execution.

Our best performing advertising circuit in the second quarter of 2010 continues to be automobiles, internet services and apparel, for the third consecutive quarter. We launched the new functions for our email service in the first and second quarters, which has enhanced both the capabilities and speed of our email services to users. As a result, our email traffic has increased as substantially compared to the industry's average. For our micro blog service, as of the end of June we have nearly 2.5 million registered users. In the second quarter we constructed a new data platform which further integrates our email blog services, blog services and (inaudible) services to drive (inaudible) to the portal.

Finally, our new social networking service product, DreamLife or Menghuan Rensheng at dream.163.com was launched on April 28. This is a product developed by our entertainment team that offers a social community with content focusing on fashions, current trends and personal light entertainment. The DreamLife community is growing steadily.

This concludes William's updates on games, advertising and portal. Now, I will provide a review of our second quarter 2010 financial results.

In order to avoid repetitions with the press release, I will primarily focus on the discussions of margins and explain fluctuations along with net profit.

Gross profit for the second quarter of 2010 was RMB878.4 million or $129.5 million, compared to RMB780.7 million RMB and RMB691.9 million for the preceding quarter and the second quarter of 2009 respectively. The quarter over quarter increase in gross profit was primarily attributable to the increased revenues from our self-developed game, Heroes of Tang Dynasty, launched in April of 2010, and World of Warcraft, again licensed from Blizzard Entertainments, as well as increased advertising service revenue partially offset by increased cost of revenues.

Increased advertising revenue was attributable to a combination of factors, as just described. Increased cost of revenues was primarily due to increased royalties and consultancy fees related to World of Warcraft operations, increasing the headcount related costs and share based compensation costs related to grants made under the new restricted shares unit plan, and increased information cost during the second quarter of 2010.

The year over year increase in gross profit was primarily attributable to increased revenue from Online Games and advertising services. Increase in Online Game revenue was mainly attributable to World of Warcraft operations, Tianxia II and Heroes of Tang Dynasty. In addition, we recognised online game revenue of RMB10.4 million or $1.5 million from the cleanup of dormant accounts in the second quarter of 2010 as compared to RMB83.3 million for the same period of 2009, resulting from a change in our user agreement with online game players implemented in May 2009.

Increased advertising revenue was attributable to a combination of factors as just described. The foregoing revenue increases were partially offset by increasing costs of revenue such as royalties and (inaudible), server depreciation charges and server custody fees related to World of Warcraft operations, accounts related costs for Online Games and advertising businesses, as well as increased share based compensation and information costs during the second quarter of 2010.

Gross profit margin for the Online Game business for the second quarter of 2010 was 71.3% compared to 72.1% and 88.3% for the preceding quarter and the second quarter of 2009 respectively. Quarter over quarter gross profit margin remains relatively stable during the second quarter of 2010. The year over year decrease in gross profit margin was primarily due to operations of Blizzard Entertainment's World of Warcraft in the current quarter. Lower margin was reported for World of Warcraft operations compared to the Company's inhouse developed games primarily because of royalties, amortisation of suppliers' fees, and technical consultancy service fees associated with the licensing and operations of this game.

Gross profit margin for the advertising business for the second quarter of 2010 was 46.4% compared to 22.9% for the preceding quarter and 16.6% for the second quarter of 2009 respectively. The quarter over quarter and year over year increases in gross profit margins were primarily due to the significant increase in advertising revenues, partially offset by a relatively small increase in cost of revenue during the second quarter of 2010.

Gross loss margin for (inaudible) for the second quarter of 2010 was 38.7% compared to 34% for the preceding quarter and 43% for the second quarter of 2009. Total operating expenses for the second quarter of 2010 were RMB268.7 million or $39.6 million compared to RMB225.7 million and RMB174.8 million for the preceding quarter and the second quarter of 2009 respectively.

The quarter over quarter increase in operating expenses was primarily due to marketing promotions for Fantasy Westward Journey and Blizzard Entertainment's World of Warcraft, increased (inaudible) provisions and increased share based compensation costs relating to awards granted under the newly implemented restricted shares unit plan in the current quarter.

The year over year increase in operating expenses was primarily due to increased advertising expanding on corporate brand building; game-specific and portal-related marketing promotional activities such as sponsorships of car and fashion shows, increased share based compensation cost; and increased headcounts related costs in the sales and marketing, general administration and research and development areas.

Net profit for the second quarter of 2010 was RMB485.7 million or $71.6 million compared to RMB452.3 million and RMB458.1 million for the preceding quarter and the second quarter of 2009 respectively.

During the second quarter we reported a net foreign exchange loss of RMB67.8 million or $10 million compared to a net foreign exchange loss of RMB39.5 million in the preceding quarter and a net foreign exchange gain of RMB47.2 million in the second quarter of 2009. 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 June 30, 2010, as the exchange rate of the Euro against RMB fluctuated over the period. In addition, we made donations of RMB15 million or $2.2 million to assist the victims of the Yushu earthquake during the second quarter of 2010.

We reported basic and diluted earnings per ADS of $0.55 each for the second quarter of 2010. This compares to basic and diluted earnings per ADS of $0.51 each for the preceding quarter and $0.54 and $0.53 respectively for the second quarters of 2009. We recorded a net income tax charge of RMB75.5 million or $11.1 million for the second quarters of 2010 compared with RMB94.5 million and RMB107.4 million for the preceding quarter and the second quarter of 2009 respectively. The effective tax rate for the second quarter of 2010 was 13.4% as compared to 17.3% and 19.8% for the preceding quarter and the second quarter of 2009 respectively.

The quarter over quarter decrease in the effective tax rate was mainly due to reversal of variations allowance resulting from the utilisations of taxable losses from prior years by one of the Company's subsidiaries in China to offset against this current quarter's taxable profits. The year over year decrease in the effective tax rate was primarily due to the fact that the local tax authority notified one of our principal subsidiaries in June 2009 that it should pay its corporate income tax liability for 2008 and the first quarter of 2009 at the rate of 12.5% instead of 7.5% based on the interpretations of the new circular issued by the state administrations of taxation in April 2009.

Cash flow generated from operating activities was RMB744.3 million or $109.7 million for the second quarters of 2009 compared to RMB676.5 million and RMB544.4 million for the preceding quarter and the second quarter of 2009 respectively.

We maintain a very strong balance sheet with ample cash resources to fund our ongoing development of world class online games, premium online content and third party licensing arrangements. As of June 30, 2010, our total cash and deposit balance was RMB8.3 billion or $1.2 billion compared to RMB7 billion as of December 31, 2009. In addition, we have a restricted cash balance of RMB32 million as of June 30, 2010, representing a security guarantee for consulting prepayments due to Blizzard Entertainment for a 12 month period to October 2010. This guarantee will be renewable annually until terminations of the licence agreement for the operations of Blizzard Entertainment's World of Warcraft.

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

Thank you, Sir. We will now begin the question and answer session. (Operator Instructions). Your first question is from the line of Richard Ji of Morgan Stanley. Please go ahead.

Good morning William and Onward. Congratulations on a strong quarter. I have two questions. Let me start with the first one regarding Fantasy Westward Journey. In the most recent month you have released a totally revamped version of Fantasy Westward Journey. So far, can you give us some colour on the user feedback for this new version, and should we be expecting a strong reacceleration of the [sales force] of Fantasy Westward Journey?

(spoken in Chinese)

Okay, maybe I'll just highlight the main points as brought up by William just now. Regarding the user feedback on our revamped version of the Fantasy Westward Journey, first of all the intentions of doing so is to allow the players or users to choose different kinds of artistic backings within the game; and we believe this would be sort of one, first of its kind in the market so far in China.

So far the user feedback has been positive. During June and July the Company has also done quite a lot of the promotional activities to inform the market about these new versions within the games. We also expect that there will be some new content and enriched information or game play to launch hopefully in the fourth quarter this year.

During July and up to mid August, during this two month period, the Fantasy Westward Journey promotion has also helped us to get a very satisfactory sales result; and we expect that a very preferable result would be delivered and reflected in the upcoming third quarter's results.

Thank you. My second question is regarding the progress of your new games, especially Tianxia II, Heroes of Tang Dynasty and your newly tested web based games. So can you also help us to have a little more understanding about their relative revenue contribution as compared with your legacy games such as Fantasy Westward Journey or even World of Warcraft.

(spoken in Chinese).

Okay, thank you William. And maybe I just highlight the main points that have been mentioned by William just now. Regarding the progress of our new games, there are quite a lot; and the first ones that are being mentioned by William would be [the Ghost], which is another MMORPG game being developed by NetEase. We expect that another new expansion pack will be launched in September this year and further information will be provided via our official game website very soon.

With regard the performance or the progress of the Heroes of Tang Dynasty, so far we have been doing quite a lot of the promotional activities for this game. In fact, we also invited another very famous martial arts actor to be our spokesperson for this game. We also expect that the performance of this game would be further increased and we are quite satisfied with the performance so far.

With regard to the progress of the games, the rest of the games, hopefully in the (inaudible) our objective is to make sure that we will continue our efforts to enhance the qualities of our games for each of our game titles to make sure that they will deliver a very good user experience to our players.

With regard to the revenue contributions, I think by now we have quite a lot of different game titles in place in the market and we still believe that we will not comment too much on the contributions for each of those in terms of the revenues.

For the Westward Journey II, there would be some new stuff that we will be doing to add in some new game play and also to enhance the technological capabilities within the games in order to enhance the user experiences to make sure that this game will continue a very good progress. In fact, on the 16 August, we have also launched a campaign to celebrate a sixth anniversary for this game. Thank you.

Yes, that's helpful, thank you.

Your next question comes from the line of Dick Wei with JPMorgan. Please go ahead.

Hi. Thanks for taking my question. My first question is on the - if you can share with us the revenue trend for some of the top games in the second quarter, and the outlook for the first quarter.

I think with regard to the revenue trend of our games, I think still they have been performing quite in line with what we have been doing in the past. Of course, our three major titles would be the Fantasy Westward Journey, Westward Journey II and III, Tianxia II and also we have also some new games with very good performance, namely the Heroes of Tang Dynasty. Of course, we also have a very good performance for the Warcraft during the second quarter.

I think this will still continue to be a trend going forward. As a recap on what William has just highlighted in the previous questions, we still look forward that especially in the third quarter and fourth quarter this year we will be expecting a much more satisfactory or more positive result delivery in terms of the gaming revenues.

Is it fair to say that for the top three games, all three games (inaudible) sequential growth in the second quarter?

Sorry, I can't hear you clearly, your question.

For the top three games, did all three games saw sequential growth in the second quarter?

I would say they have been performing quite satisfactorily during the second quarter.

With the - can you tell us, in terms of the sales marketing expenses in the third quarter, what kind of spending should we be looking at? And if you have more sense in their capacity as well, that would be helpful. Thanks.

In terms of the selling and marketing expenses, I think we have earlier mentioned that starting from the first quarter of 2009, the Company has decided to invest more in this area to promote both the different products of the Company, whether they are the game (inaudible) products or our portals or even being some corporate brand building. For 2010, I think the current levels of selling and marketing spending will be very good indicators on what we would continue to spend in the upcoming quarters.

So as far as the margin is concerned, it's probably going to be similar to the second quarter?

Yes, right.

Great, thank you very much.

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

Hi, good morning William and Onward and Brandi. So two questions - number one on the World of Warcraft. Can you give us some highlight why the second quarter trend has been doing so well? Is it because of your continuous promotion of World of Warcraft (inaudible) relatively low seasonality? Also, can you also comment about the version of the recently approved of World of Warcraft? There's some report saying it's a limited version. What is the meaning of it and is there any content difference from the US version?

My second question is on the StarCraft. So given the recent approval of Wrath of Lich King, does it mean that the StarCraft launch phase will be relatively more visible right now? Thank you.

(spoken in Chinese)

Regarding the first questions, I think basically the good performance for World of Warcraft in second quarter is mainly due to two sides. First of all, the business R&D team has worked out a very good quality product that is very receptive to the market and the players alike. On the other hand, the business also delivered a very good execution capability in operating games in terms of our distribution channels as such. This also helps to explain why the performance for this game in second quarter was very satisfactory.

With regard to the rumours about the approval on whether or not the current version is limited one or not or whether it somewhat will be different from the versions in the States, I think the fact is that on the 17th of August we have already started the downloading process for the players of the new content of the expansion packs. We think it will be better for the people or the players to compare the content as soon as the game becomes launched, so that they can also assess whether this is the same or different from the versions from the other place.

At all times, the Company would respect the users' experiences on playing the games, but at the same time we also would respect the importance of maintaining a balance of delivering the product in the China market which would be able to comply with the relevant rules and regulations in the Chinese restrictions.

(spoken in Chinese)

There is another supplement by William regarding the first questions brought up by Wallace. We will say that we would be the ones who are most familiar with all the changes within the game itself. At all times this is not necessary or at all meaningful to read too much about the rumours (inaudible). We also want to reiterate again that both NetEase and Blizzard respect the users' gaming experiences on with every new launch of the game that we intend to do in the market. Thank you.

(spoken in Chinese) So my question is the second tier cities promotion is one of the key reasons for the growth of World of Warcraft in the second quarter. My second question is for the StarCraft II timetable. Thank you.

(spoken in Chinese)

Okay. Just now William has highlighted that in the early morning on 17 August, the Company has already started to allow the players to download the plug-in for the new expansion packs because the size of this expansion pack is quite large, almost about 2.5 gig, so it would take some time for them to complete all the downloading and the installations. As soon as those preparations were actually completed, we would make an announcement on the launch of the games very soon. So each of the players and everyone, every interested party, can watch on our official website for more information.

With regard to the promotions of the games in the Tier 2 and 3 cities, we still believe that this will be much of our primary web focus for further promoting our games in the China market and we would try our very best to make sure that this will be a success as well.

Thank you.

Thank you. Your next question's from the line of Alicia Yap with Citigroup. Please go ahead.

Hi, good morning William, Onward and Brandi. My first question is regarding Tianxia II. Since the official launch of the game a year ago, since that game's performance has been improving each quarter and continues to contribute more meaningful revenues to the overall portfolio, given so many new games launched in China over the past two years actually have failed to draw attractions, can you share with us what are some of the factors that attribute to the success of Tianxia II? And what are some of the different [shaded] game features or design that you have, or was that also attributed to good marketing initiatives and also understanding of gamers' needs?

Similarly, what are the factors that you believe contributed to the better than expected traction on Heroes of Tang Dynasty?

(spoken in Chinese)

This is William. To summarise what William has just highlighted, first of all I think that we would just like to make sure that the group performance of our online gaming business is not solely attributed to our newly launched or implemented games, but rather this would be a comprehensive result on all of the games that we have launched in the market. In fact our Fantasy Westward Journey and Westward Journey II and III are also very successful gaming titles in the market which are not ignored for their contributions to the market.

To summarise the main points on our Group performance on the online gaming business, there would mainly be three. First of all, the users' needs and expectations are highly regarded by us and would also be taken by us seriously in order to enhance and improve the content or the game play, the features within the game. From time to time, we would be getting timely and regular feedback from our users; and in fact, our players, our customers, are actually the ones who must make our games better to improve our game standard and to serve them better. You would also see that almost on a weekly basis from time to time whenever the Company gets any new feedback from users, we would also put up some new patch to enhance the game itself.

The most important aim or objective that we would like to achieve is to make sure that the users' gaming experiences would be enhanced and attended to at all times.

Secondly, we would like to highlight that we are a company with a very long term vision and we will not do anything to hurt the interests of our players by making just (inaudible). This is also a wish and philosophy that we share with our [RMP] team people alike.

Thirdly, with regard to the product features, whenever we find there are some features within the games that are very appealing to our players and users, then we would also at the same time invest more to do more promotions to the game as well. And to share with you, during June and July this year, through the introduction of our new spokesperson Jay Chou, we have done lots of promotions and activities in the media for the Fantasy Westward Journey. That's why so far we have been receiving very promising and positive feedback from the users and also believe that this will help to make a very good revenue contribution to us in upcoming quarters.

With regard to the performance or the upcoming progress for the Westward Journey II, in fact we expect and plan to launch another expansion pack hopefully in September this year in order to further enrich the gaming experiences of our key players; also the same thing with the (inaudible) for the Heroes of Tang Dynasty as well.

In summary, from our long term visions, we believe that through the various means that we have been doing so far, we believe that the upcoming road ahead of us we would be suffering less and less failures and making sure that at all times we would be a very successful online gaming company. Thank you.

Thank you for a very comprehensive answer. My second question is regarding World of Warcraft. So can you share with us some of the progress that you are working on bringing the game into the second and third tier cities? Based on your survey and some of the market research, how big is the potential for World of Warcraft in those cities and how much more potential in terms of (inaudible) growth from those cities?

(spoken in Chinese)

Okay, we'll wait for your good results. And--

(multiple speakers)

(spoken in Chinese)

This is William. Basically I think we believe that the questions being brought up by Alicia would be a little bit too detailed, but in general this is somewhat kind of the management kinds of issues that we are dealing with on a daily basis. At all times we are more than other people's - that we understand what we are actually doing and hopefully we have a very good grasp on the market demographic or how the market is going, and we would be doing our job accordingly.

Thank you. My last question is on the housekeeping questions on the G&A increase. So it seems a little bit higher than expected. Was that mainly due to higher share based compensation? And what is the amount of the [net debt] provision? Regarding the tax rate, what should we be expecting for the rest of 2010 and '11?

I think you're quite right in saying that the increase in G&A expenses would mainly be brought about by the share based compensations course because we've just implemented another new [recipient shares units plan] in the second quarter.

Also, we believe that, in terms of the effective tax rate, I think we still would like to advise that for on an annualised basis, we'll still suggest to use the range of 18% to 23% for the time being.

Thank you. Thank you for taking my questions.

Thank you. Ladies and gentlemen that's all the time we have for questions today. At this time I'll turn the conference back to Ms Brandi Piacente.

Thanks. For anyone that had questions but didn't get them answered, we had obviously the Q&A went a little bit longer with just a few questions, so I'd encourage you to put them in your one-on-one's or contact us so we can help you.

So anyway, feel free to contact us and I hope you all have a good day. Thanks.

Thank you, ladies and gentlemen. This does conclude the NetEase second quarter 2010 earnings conference call. Thank you for your participation; you may now disconnect.