NetEase Inc (NTES) 2010 Q3 法說會逐字稿

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the NetEase third quarter 2010 earnings conference call. During today's presentation all parties will be in a listen only mode. Following the presentation the conference will be open for questions. (Operator Instructions).

This conference is being recorded today, Wednesday 17 2010. I would now like to turn the conference over to Miss Brandi Piacente, Investor Relations. Please go ahead, ma'am.

Thank you, operator. Please note that the discussion today will contain forward looking statements relating to future performance of the Company and are intended to qualify for the safe harbor for my ability, as established by the US Private Securities Reform Act.

Such statements are not guaranteed 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 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 20F. 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 at 63.6% year over year, to RMB1.4 billion or $215.1 million. Revenue from online games increased at 52% year over year, to RMB1.3 billion or $187.7 million. Primarily driven by World of Warcraft again likely from Blizzard Entertainment and our self developing Heroes of Tang Dynasty and Tianxia II.

Revenues from advertising services grew 88.3% year over year, to RMB162 million or $24.2 million.

Our quarterly net profit increased 48.6% year over year to RMB585.3 billion or $87.5 million with basic and diluted earnings per ADS of $0.57.

On a sequential basis total revenue increased 6.8%. Revenues from online games increased at 6.4% and revenues from advertising services increased at 11%. Net profit increased at 20.5% quarter over quarter and included a net foreign exchange gain of RNB54.3 million or $8.1 million.

In online games Fantasy Westward Journey continued to perform well during current quarter, resulting from success in our large scale sales promotional and branding activities and driving the majority of the sequential online games revenue growth, quarter over quarter.

Fantasy Westward Journey beat its August 2009 record for peak concurrent users on 4 July 2010. The game remains one of the most popular animal games ever in the Chinese market. We continue to work on the creativity and functionality of this game and, in fact, to release its next expansion pack in the first quarter of 2011. Expansion packs for Westward Journey Online II and III were released during the first quarter, on schedule.

Performance of Heroes of Tang Dynasty remain very strong, in terms of revenue, user stats and other data. Given the popularity of this 2.5D item based game we are working on expanding our market share in this arena with new games such as Ghost, which had a closed beta testing on 22 July 2010 and started to generate revenue during the third quarter.

Tianxia II celebrated its one year commercial anniversary on 28 September with the launch of its new expansion pack, Secret of Dream Dragon. The World of Warcraft expansion pack Wrath of the Lich King™ was released in China on 31 August 2010 to tremendous player enthusiasm. World of Warcraft is the well renowned massively multi-player online role playing game with very strong vision of promotional and sales support. We are optimistic about these continued growth opportunities throughout China.

Now, turning to portal activity, during the first quarter we sponsored and conducted promotional activities for the 16th Asian Games in Guangzhou, a major national event. This was a major driver of our solid growth rate, along with traditional seasonality in advertising activity.

Our top five performing advertising status in the first quarter of 2010 were automobile, internet services, apparel, finance, and beverages. We made a number of portal contents and channel enhancements during the third quarter and created additional ad space on several of our more popular pages. We launched a new ad placement system that had greatly improved user preference tracking and resourced utilizations and statistical data gathering - a great value to advertisers.

Such ongoing advancements and integrations of technology channels and product have attracted advertisers' attention and has been driving increasing demand for our advertising services. Meanwhile, the content enhancements have driven improvement in our overall user traffic statistics.

Our micro-blog service grew from 2.5 million registered users at the end of June, to over nine million registered users as of 30 September 2010. We added important functionality to this service during the third quarter, including integrations with our email services, so that users can access and update their micro-blog account using NetEase email or simultaneous (inaudible) updates.

In search, new versions of Youdao Dictionary version 3.2 and 3.3 were released during the first quarter and updates were implemented in our mobile dictionary. We believe we have the market leading online dictionary, and preparations for our next major release are underway.

Finally, email performed very well again during the third quarter. As the number one email service provider in China since 2003 we now track over 350 million active users.

Our overall portal ranking within China has increased, driven by two highest ranking statistics for (inaudible), average hours per week per NetEase user of 22.9 hours and internet lock-in by NetEase users of 18.3 times per month. Year to date our portal traffic has increased to 40%. All of these, in turn, have increased the advertising return on investment.

Overall the third quarter market (inaudible) consecutively strong quarter of growth and innovations in our portal business.

This concludes William's updates on games, advertising and portal. Now I will provide a review of our third quarter 2010 initial results. I will primarily focus on the discussions of margin and expense fluctuations, along with net profit. Gross profit for the third quarter of 2010 was RMB959.2 million or $143.4 million, compared to RMB878.4 million and RMB627 million for the preceding quarter and the third quarter of 2009, respectively.

The quarter over quarter increase in gross profit was primarily attributable to increased games revenues from Fantasy Westward Journey during the third quarter of 2010, as well as increases in advertising services revenue and non-recurrence of certain events based information costs incurred in the third quarter.

The increase in advertising services revenue was attributable to a combination of factors, including, primarily, Asian Games and related advertising, seasonality and improved portal traffic.

The year over year increase in gross profit was primarily attributable to increased revenues from online games and advertising services. The increased online game revenue was primarily attributable to The World of Warcraft, Heroes of Tang Dynasty and Tianxia II. Increased advertising services revenue was attributable to the combinations of (inaudible) as just described.

The foregoing revenue increases were partially offset by increased costs of revenue, such as royalties and consultancy fees, certain depreciation charges and other fees related to World of Warcraft operations and an increase in head count related costs for online games and advertising services businesses during the third quarter of 2010.

Gross profit margin for the online game business for the third quarter of 2010 was 72%, compared to 71.3% and 79.9% for the preceding quarter and the third quarter of 2009, respectively. Quarter over quarter gross profit margin remained relatively stable during the third quarter of 2010. The year over year decrease in gross profit margin was primarily due to the reporting of a two quarters result for World of Warcraft in the current quarter, as the game was officially re-launched at the end of September 2009.

Lower profit margin was reported for World of Warcraft operations compared to our self-developed games, primarily because of royalties, amortizations of license fees, technical consultancy service fees and server depreciations associated with the licensing and operations of this game.

Gross profit margin for the advertising services business for the third quarter of 2010 was 54.2%, compared to 46.4% and 23.1% for the preceding quarter and the third quarter of 2209, respectively.

The quarter over quarter and year over year increases in gross profit margin were primarily due to the significant increase in advertising services revenues during the third quarter of 2010, as well as the non-recurrence of certain events based information costs incurred in the prior quarter.

Gross loss margins for the wireless (inaudible) services and (inaudible) business for the third quarter of 2010 was 41.3%, compared to 38.7% and 45% for the preceding quarter and the third quarter of 2009, respectively.

Total operating expenses for the third quarter of 2010 were RMB372.2 million or $55.6 million, compared to RMB268.7 million and RMB218.9 million for the preceding quarter and the third quarter of 2009, respectively.

The quarter over quarter increase in operating expenses was primarily due to marketing and promotional costs incurred for Fantasy Westward Journey, Heroes of Tang Dynasty, World of Warcraft and Tianxia II and increased staff related costs resulting from new search and development headcounts in the areas of search and online game businesses. This was partially offset by the decreased bad debts provisions as a result of improved control over long outstanding accounts receivable and satisfactory legal settlements of a long outstanding account receivable balance during the current quarter.

The year over year increase in operating expenses was primarily due to increased marketing promotional costs and increased staff related costs in the current quarter, as previously explained.

Net profit for the third quarter of 2010 totaled RMB585.3 million or $87.5 million, compared to RMB485.7 million and RMB393.8 million for the preceding quarter and the third quarter of 2009, respectively. During the third quarter of 2010 we recorded a net foreign exchange gain of RMB54.3 million or $6.1 million, compared to a net foreign exchange loss of RMB67.8 million in the preceding quarter and a net foreign exchange gain of RMB25.3 million in the third quarter of 2009.

The quarter over quarter and year over year changes in foreign exchange gains and losses were mainly due to the translation changes arising from the Company's Euro Denominator bank deposit balances as of 30 September 2010, as the exchange rate of the Euro against the RMB fluctuated over the periods.

We reported basic and diluted earnings per ADS of $0.67 each for the third quarter of 2010. This compares to basic and diluted earnings per ADS of $0.56 and $0.45 each for the preceding quarter and the third quarter of 2009, respectively.

We recorded a net income tax charge of RMB91.3 million or $13.6 million for the third quarter of 2010, compared with RMB75.5 million and RMB65.5 million for the preceding quarter and the third quarter of 2009, respectively. The effective tax rate for the third quarter of 2010 was 13.7%, as compared to 13.4% and 14.3% for the preceding quarter and the third quarter of 2009, respectively.

Cashflows generated from operating activities were RMB532.6 million or $79.6 million for the third quarter of 2010, compared to RMB744.3 million and RMB270 million for the preceding quarter and the third 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 30 September 2010 our total cash and term deposit balance was RMB8.8 billion or $1.3 billion, compared to RMB7 billion as of 31 December 2009.

Thank you for your attentions. We will now be happy to take your questions. Operator, please go ahead. (Operator instructions).

Our first question is from the line of Dick Wei with JP Morgan. Please go ahead.

Hi, morning. Thanks for taking my questions. My first question is that if you can share with us the sequential growth rate for each of the leading games- if you can put some more color to the sequential growth rate, that would be helpful. Thanks.

I think, in general, regarding the sequential growth rate for each of the games, I think basically we wouldn't break that out. In general what we would say is that for the past quarters, in the third quarters, we observed that for all of our core and legendary game titles, including the Fantasy Westward Journey, the Westward Journey II and III, Heroes of Tang Dynasty, Tianxia II and also World of Warcraft, they have been performing quite progressively, especially the third quarters would be our peak season across the whole year. We also experience very good feedback from our players and from those games because, as you are aware, we have been launching numbers of (inaudible) and promotional activities throughout the third quarter.

Great. I wonder if William can give some of your thoughts on the (inaudible) game market, going forward.

William, (speaks in Chinese).

The next question is from the line of Alicia Yap with CitiGroup. Please go ahead.

That's okay. Alicia, please go ahead.

Oh, hi, good morning. Sorry. Yeah, so my question - thanks for taking my questions. Number one, is can you share with us how many new advertisers you actually have been able to attract for your sponsorship for the Asian Games? Also, have specific advertising categories experienced strong sequential growth or year-on-year growth?

I think with regard to the recruitment of the new advertisers due to the Asian Games, I think there wouldn't be any specific data or numbers correlated to this single event. But in general we still hold a positive will on the overall - on the advertising market outlook, because through this year, apart from the Asian Games we also had other big events like the World Expos, and also the World Cup. That has happened earlier this year. Together with the enhancements of the content in channels initiative that our portals are offering, we believe this would be a comprehensive factor in contributing to the growth in our advertising numbers.

Fantastic. Secondly on your social marketing expenses actually increased very significantly during the quarter. Should we assume a major proportion of that is actually related to World of Warcraft promotions? Would you expect the fourth quarter to be a similar, or should we expect it to be moderate?

With regard to the sales and marketing expenses, what we'll say in the third quarter is we have launched a number of big scale sales and promotional events and activities, including our appointment of the spokespersons for the three self-developed legendary game titles, including the Fantasy Westward Journeys, the Heroes of Tang Dynasty, and also Tianxia II.

For Fantasy West Journey we have Jay Chou to speak for us, and we have also launched a series of promotion events and activities during the third quarter. As for the Heroes of Tang Dynasty, we have also found a very popular martial arts pop star (inaudible) to speak for us. For the Tianxia II we have found another popular singer in China, called (inaudible).

I think those three spokespersons and the various sales and marketing promotions, events and activities launched during the third quarter have contributed to part of the increase in our sales and marketing expenses. Apart from that, of course, we also have our launch of the World of Warcraft expansion packs, and the Wrath of the Lich King. We have also increased our expenses in this respect. This explains why in the third quarter the amount of the total sales and marketing expenses incurred were much higher compared to the previous two quarters.

Going forward in the fourth quarter we foresee that the spending wouldn't be as high as the third quarter. It will be more in line with what we have been spending in the first two quarters of this year.

Okay. That's very helpful. Lastly, any updates that you can share or provide in terms of StarCraft II localisations, and also the testing status? Thank you.

With regard to StarCraft II development, at the moment we have already submitted information and materials to the relevant government authorities undergoing the review process. As soon as we get all the relevant approvals from the government authorities, then we will have more concrete timelines on when it will be launched.

Okay, great. Thank you. Congratulations on the strong quarter.

Thank you.

Thank you, and we do have a quick follow up question from the line Dick Wei. Please go ahead.

Hi, thanks for my questions again. Yeah I just wonder if you can share a view on the latest market update on competition or challenges? (Spoken in Chinese)

(interpreted) For some comments in William's remarks on the outlook in general regarding on the online games market, basically William is of the opinion that he still feels that the market is very good, and as long as the game operators have some very good products in place, and offering to the markets and the place in general, then this will have a very good growth opportunity, especially in this market.

For NetEase itself, who are in the online game market, we believe that we would sustain our very best efforts in always enhancing our qualities of products, and rolling out some very good stuff to the market.

Okay, thank you, and congratulations on a good quarter.

Thank you, and our next question is from the line of Timothy Chen with Morgan Stanley. Please go ahead.

Hi William, Onward and Brandi, good morning. Thanks for taking my questions. My first question is about your very solid game performance in this quarter. Can you actually share with us some of the factors of success for the Fantastic Westward Journey? Is it due to the appointment of a spokesperson, or do you have any new promotional initiatives in this quarter? If you could also talk about the performance of World of Warcraft after the launch of the expansion pack in September, that would be great. Thank you.

Basically the appointment of the spokespersons for Fantastic Westward Journey is just one of the means for us to promote our games for the game titles, but apart from that we believe that there are many other elements in attributing the success of a particular game. We always believe that the enrichments of the contents of the game itself is also very important. We would not think that simply appointing a new spokesperson, or to just produce some advertisements would be the sole success for the game's performance.

With regard to the launch of the new expansion packs for the Fantastic Westward Journey, as we have mentioned already in the press release, the next expansion packs will hopefully come out in the first quarter of 2011. The new expansion packs will hopefully introduce new game plays, features, and also have some more content enrichment to attract the players of the games.

Can you also comment on the performance of World of Warcraft after the launch of the expansion pack for Wrath of the Lich King in September, that would be great. Thank you.

Sorry, I cannot hear your questions clearly because the line is not good.

Okay, let me repeat. I would like to understand the performance of World of Warcraft after the launch of the expansion pack for Wrath of the Lich King in September.

Okay. With regard to the performance of Wrath of the Lich King since its launch at the end of August, the responses from the place has been very good and positive. We have also seen that the game has been performing (inaudible).

Okay, thank you very much.

Thank you.

Thank you, and our next question is from the line of Eddie Leung with Bank of America. Please go ahead.

Good morning everyone. Congratulations on a good quarter. I have a couple of questions. The first one is what can you guys share with us about your game pipeline for 2011? My second question is on your operating cashflow. It seems to date versus the second quarter could you also elaborate more on the decrease in operating cashflows this quarter? Thank you.

(Interpreted) I think with regard to the game pipelines for the next year I think there will be quite a number of works that we'll be doing in the first half of next year. Of course from time to time we will be undergoing some new development until it comes to a more appropriate timing then we will update on the new games' roll out in the upcoming years.

With regard to the second question regarding the operating cashflows as compared with the second quarter. There has been a drop in the net cash provided by the operating activities mainly because we have also paid out some royalties in the third quarter.

Got that. Just a thought or impressions on the Ghost story. How many years have you guys invested in the game so far? Thanks.

(Interpreted) Almost three years.

Thank you very much.

Okay.

Thank you. Our next question is from the line of Ming Zhao, with Susquehanna Financial Group. Please go ahead.

Sorry, thank you very much. Just one question on the advertising side. You said the growth in advertising is helped by the Asian Games but Asian Games is held in the fourth quarter. So could you explain why you are able to get more revenue in the fourth quarter for the Asian Games. So why are you able to get more revenue in the third quarter?

Ming, I think basically with the regard to the growth in our advertising revenue in the third quarter of course the Games themselves will happen in the fourth quarter specifically starting in the middle of November. But usually we also observe that the advertisers somehow will do some advance preparation and do some advance marketing and spending on promotional events well ahead of the Games happening.

So I think this would somehow be also a normal trend as we have observed so far.

Okay, but would you say that the fourth quarter advertising revenue would get more benefit from the Asian Games than this third quarter?

What we are saying is that in general we would also see that the advertising revenues will be growing progressively throughout the year. Both in line with seasonality and also undertaking of some major events during the quarters.

Okay then what about the cost of sponsoring the Asian Games. How big is that and is that going to be occurring, all of them occurring in the fourth quarter?

I think definitely as the sponsors of these very important events where will be some sponsorship amounts that will have been spent. I think we will update the more concrete figures maybe at a later stage.

All right, thank you.

Thank you. Our next question is from the line of Gary Ngan with UBS. Please go ahead.

Hi, good morning everyone. I have a couple of questions. So firstly can you share with us for Fantasy Westward Journey how many people, or what's the proportion of people actually playing their way (inaudible) versus the original version? So and the follow up is like, how important do you think are graphics to online gaming?

(Interpreted) I think the major highlights by William would be that with regard to the percentages or the proportions of the players in our classic versions and the (inaudible) of the Westward Journeys we will not be providing further breakdown as such.

But with regard to Gary's second question regarding how important is graphics to the online games. The answer is that the graphics are a very important part in actually leading to the success of an online game. This is one of the very important elements and if the graphics are good enough it can also make the players' gaming and users' experience much better.

It will make them feel more real in the virtual world as such. As the technologies are moving forward then we also believe that we will also be working hard to introduce much better and a different kind of graphical perceptions and gaming experiences to the users in general.

Thanks a lot. If I can also ask a follow up? I just want to get William's view towards MMORPG's future versus other types of games' future? So especially what kind of other categories of games would William think are going to have a bigger potential. Like is that going to be shooting, or strategy or action games? Any thoughts would be very much appreciated.

(Interpreted) William highlighted that for what other game types including the shooting ones, the action ones, the strategy ones, all of those will have their unique potential in developing in the online game market. We also believe that for all these kinds of games it is also worth for the companies to invest as such.

That's very helpful, thank you. (Spoken in Chinese)

(Spoken in Chinese)

Thank you. Our next question is from the line of Atul Bagga with ThinkEquity. Please go ahead.

Hey guys, thanks for taking my call. I just wanted a little bit to understand the sales and marketing expense and can you talk a little bit about how the cost of acquisition might be trending. Are you seeing the cost of acquiring the users going up and if so how much is that?

Also I don't know if you can talk a little bit about what's happening in terms of numbers which growth and future use? Is it mostly from the (inaudible) users or are you also seeing growth coming from the new users?

Sorry, Atul, with regard to your first question about the sales and marketing expenses, would you mind repeating it again because I couldn't grasp your questions fully?

Sure, I wanted to understand the cost of acquisition, the cost of user acquisition. How is that trending. If it is going up what is it about , it is mostly because of the competition? Is it going up because the advertising cost is going up. Any color you can give on the cost of user acquisition will be

Okay with regard to the sales and marketing expenses that have been incurred I think there would not be a very specific correlation on how much of sales would help us to get new users or new advertisers in general. But what we would say is that it behoves sales and marketing expenses will be a comprehensive program that we will be doing at two levels, one at the corporate level in building up our own brands and the second level will be directed more specifically towards our respective titles, including our game titles and whatever products that we would like to promote.

At all times from what we have been doing so far by increased sales and marketing expenses we do see that there has been a very good and progressive development in our business in general. So I think at the same time the Company will also make some consideration on when, how and what should we do in order to get more users or players that we would like to target.

With regard to your second question regarding the PCU numbers for our Westward Journey games, I think because this is what we have mentioned earlier this year, we wouldn't be giving out further PCU numbers for each of our games. But what we will say that from the performance of the games so far in this year, we have seen that the numbers of our players has been going safely and progressively.

Yes, excellent. I was trying to understand if the growth in PCU or ACU for these games for Westward Journey as well as for World of Warcraft, is this mostly coming from the existing users that is driving better stickiness or is it more about driving, a wider, broader user base?

Yes I think both ways but as always there wouldn't be any further specifics that we can provide.

Fair enough thank you.

Okay, thank you.

Thank you. Our next question is from the line of Doug Creutz with Cowen and Company. Please go ahead.

HI, yes, thank you. You continue to drive a lot of free cashflow and I was wondering if you could update us essentially with your thoughts on how you are thinking about using that cash? Can we expect a share buyback or a dividend at some point? Thank you.

Yes, thank you. Sure, definitely with regards to the potential use of our free cash I think there would be three areas that we have always saying that the Company has been considering. One of those would be a potential share buyback and hopefully, maybe some dividend payout or even further co-operations with some licensing opportunities.

But at this stage I think there is no further updates that the Company will be giving out as yet. But we have been considering it for the time being.

Okay, thank you.

Thank you. Our next question is from the line of Lisa Li Hui Yang with Goldman Sachs. Please go ahead.

Oh thanks for taking my questions. Could you share with us how we should look at your game business even now being fourth quarter? My second question is regarding your tax rate in the fourth quarter and 2011? Okay.

Okay thank you.

(Interpreted) I think basically with regard to our game developments I think we will still continue with our efforts in making sure that the quality of our games is very good. Although the market competition is very intense and severe now but given the efforts that we have put in and the quality of the product that we actually give out to the market, we believe that we will also see some good results from there.

Lisa, with regard to your second question regarding the effective tax rate. Maybe I will just put it this way. By now we would expect that the annualized ETR would be somewhere around the 13% to 16% range given that because we are moving towards the end of this year and we have been undergoing the annual review and the applications to various tax of royalties in confirming some tax basis.

So I think at this stage we foresee that it will be somewhere around in the 13% to 16% range.

Thanks for taking my questions.

Thank you. Our next question is from the line of Tian Hou, with Auriga. Please go ahead.

Hi there, William and Onward. The question is very simple. I saw the share based compensation just went up a lot. So what is the trend in that (inaudible).

Sorry Tian, the reception of the line is not very clear, would you mind repeating your question again?

So its' about share based compensation and in quarter 3 share based compensation jumped up a lot. So I just wondered what is the trend going forward?

I think basically just as what we have highlighted in the last quarter's earnings because we have also introduced a new RSU program for the employees of the Company in generally. This definitely will have then (inaudible). So the increment in terms of the SBEs to the Company are light.

As we move forward I think there will also be a trend that there will be some increase in the SBE cost. But I think at this stage this will not be very specific projections on how much this will be increased. But I think this will be happening down the way.

Okay, thank you, that's all.

Okay, thank you.

Thank you, ladies and gentlemen, that concludes the question and answer session. I would now like to turn the call back over to Ms B Brandi Piacente then for closing remarks.

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

Ladies and gentlemen this concludes the NetEase third quarter 2010 Earnings Conference Call. (Operator Instructions) Thank you for your participation. You may now disconnect.