NetEase Inc (NTES) 2010 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the NetEase Fourth Quarter 2010 Earnings Call. (Operator Instructions).

This conference is being recorded today, Wednesday, 23 February, 2011. At this time I'd like to turn the conference over to Brandi Piacente, Investor Relations. Please go ahead.

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 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 those discussions. 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 website 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 marks on behalf of Mr William Ding, Chief Executive Officer of NetEase.

Thank you, Brandi. Please note that for the purposes of this discussion, all percentages are based on RMB. For fiscal year 2010 we delivered total revenue growth of 48% to RMB5.7 billion or $857.5 million compared to 2009. Revenues from online games increased 46.8% to RMB4.9 billion or $749.2 million and revenues from advertising services increased 65.1% to RMB633.2 million or $95.9 billion. For the fourth quarter of 2010, total revenues increased 30.2% year over year and 16.7% quarter over quarter to RMB1.7 billion or $254.5 million. Revenues from online games increased to 30.7% year over year and 13.3% quarter over quarter to RMB1.4 billion or $215.5 million for the fourth quarter of 2010.

Our fourth quarter revenue growth was primarily driven by the Wrath of the Lich King expansion pack launched on 31 August, 2010, for World of Warcraft, a game licensed from Blizzard Entertainment, and outstanding performances from our fastest growing self-developed games, Tianxia II and Heroes of Tang Dynasty, as a result of launch of expansion packs for these games. Westward Journey Online II also performed well, benefiting from large scale promotional activities in the first quarter and improved games design implemented in the fourth quarter of 2010. In addition, Fantasy Westward Journey contributed to the year over year revenue increase, resulting mainly from increased promotional activities held in the second quarter of 2010.

For the full year, our outstanding revenue growth of 47% in online games was mainly attributable to the combinations of the first two years of operations of World of Warcraft and the impact of successful large scale promotions for Fantasy Westward Journey, Tianxia II and Westward Journey Online II, as well as the launch of Heroes of Tang Dynasty in April 2010 and its first expansion pack in August of 2010.

During the fourth quarter of 2010 we were pleased to see that revenue from Westward Journey Online II reached a new high. Fantasy Westward Journey's 10th expansion pack was released just after year-end in January 2011. The latest expansion featured a new story line and setting and added new characters that enhanced the game's visual appeal and challenge for players.

The next expansion pack in process for release in 2011 includes updates for Tianxia II, Heroes of Tang Dynasty, (inaudible), Westward Journey Genesis, among others. Overall, game expansion and pipeline development is proceeding well and our top strategic priority in online games this year includes accelerating our product development time to market and further enhancing our highly competitive and innovative technology and commercial appeal.

Now, turning to advertising and portal activities, fourth quarter revenues from advertising services grew 37.2% year over year and 44.2% quarter over quarter to RMB233.7 million or $35.4 million. These increases in advertising services revenue were attributable to a combination of factors, including primarily increased advertising related to the 2010 Asian Games, and improved portal and search traffic on our websites.

Seasonality also contributed to the quarter over quarter increase for the fourth quarter of 2010. The 65% increase in advertising services revenue for the full year of 2010 was attributable to a combination of factors, including primarily improved Chinese economy, increased advertising related to major events such as the 2010 FIFA World Cup, Expo 2010 in Shanghai and the 2010 Asian Games, and improved portal and search traffic on NetEase's websites, which was partially offset by increased staff related costs resulting from increased head count and performance based compensation as well as increased content costs related to the World Cup, Asian Games and the Shanghai Expo in 2010.

Our large investment in promotional activities through sponsorship and support of major Chinese national events and programs in 2010 paid off well. Through these initiatives we believe we successfully raised our [portal] standing and delivered outstanding value for money advertising services to our advertisers. Our top performing advertising sectors in the fourth quarter of 2010 were automobile, internet services, consumer electronics, apparel, and food and beverages, with consumer electronics replacing financial services as a top spending category.

In 2010 our improved internal organizational structures supported excellent sales executions and customer relationship development. We also integrated a number of new products, services and channels into our portal that has drawn a substantial number of new users and improved user traffic statistics. This achievement puts us in an excellent position to proceed with strategic plans in 2011.

This year we will be focusing on new product applications for mobile phones to position ourselves at the forefront of trends and innovations in this market. We will also be exploring new advertising formats and marketing models to attract premium advertisers and stimulate [ad] spending. We are working to achieve healthy growth across our business in 2011, in line with anticipated market expansions, in order to maintain our leading position in China's burgeoning internet community. This concludes William's updates on games, advertising and portal.

Now I will provide a review of our fourth quarter and fiscal 2010 financial results. I will primarily focus on the discussions of margin, and explain fluctuations, along with net profit. Beginning with fourth quarter 2010 results, gross profit for the fourth quarter of 2010 was RMB1.1 billion for $168.7 million compared to RMB952 million and RMB838.4 million for the preceding quarter and the fourth quarter of 2009 respectively.

So quarter over quarter and year over year increases in gross profit were primarily attributable to increased revenues from both the online games and advertising businesses, partially offset by increased cost of revenues such as royalties and consultancy fees related to World of Warcraft operations and increased staff related costs resulting from increased head count in the current quarter.

Gross profit margin for the online game business for the fourth quarter of 2010 was 71.8% compared to 71.8% and 70.5% for the preceding quarter and the fourth quarter of 2009 respectively. Gross profit margin for the advertising business for the fourth quarter of 2010 was 53.5% compared to 51.5% and 56.6% for the preceding quarter and the fourth quarter of 2009 respectively.

The quarter over quarter gross profit margin remained relatively stable. The year over year decrease in gross profit margin was primarily due to increased staff related costs and content costs in the fourth quarter of 2010. Gross lost margin for the wireless value-added services and others business for the fourth quarter of 2010 was 19.7% compared to 42.4% and 40.4% for the preceding quarter and the fourth quarter of 2009 respectively.

Total operating expenses for the fourth quarter of 2010 were RMB320.7 million or $48.6 million compared to RMB365 million and RMB231.3 million for the preceding quarter and the fourth quarter of 2009 respectively. The quarter over quarter decrease in operating expenses was primarily due to reduced selling and marketing expenses, partially offset by a change in [bad debt] provisions.

The decrease in selling and marketing expenses was primarily due to the non-recurrence of marketing promotional expenses associated with the celebration of the first anniversary of Tianxia II in the preceding quarter. The year over year increase in operating expenses was mainly due to increased selling and marketing expenses, mainly compromising the amortizations of certain contractual [clause] for product [expenses] related to Fantasy Westward Journey, Heroes of Tang Dynasty and Tianxia II, launched in the first quarter of 2010. In addition, increases in staff related costs in the current quarter resulting from head count increases in the areas of general and administration and research and development also contributed to the year over year increase in operating expenses.

Net profit for the fourth quarter of 2010 totaled RMB712.5 million or $108 million compared to RMB585.3 million and RMB571.8 million for the preceding quarter and the fourth quarter of 2009 respectively. During the fourth quarter of 2010 we reported a net foreign exchange loss of RMB36.4 million or $5.5 million under other net, compared to a net foreign exchange gain for RMB54.3 million for the preceding quarter and a net foreign exchange loss of RMB15.3 million for the fourth quarter of 2009.

Quarter over quarter and year over year foreign exchange gains and losses were mainly due to the translation gains and losses arising from our euro denominated bank deposit balances as of 31 December, 2010, as the exchange rate of the euro against the RMB fluctuated over the period. We reported basic and diluted earnings per ADS of $0.83 each for the fourth quarters of 2010. This compares to basic and diluted earnings per ADS of $0.68 each and $0.67 each for the preceding quarter and the fourth quarter of 2009 respectively.

We recorded a net income tax charge of RMB83.2 million or $12.6 million for the fourth quarter of 2010 compared to RMB91.3 million and RMB71.2 million for the preceding quarter and for the fourth quarter of 2009 respectively. The effective tax rate for the fourth quarter of 2010 was 10.3% as compared to 13.7% for the preceding quarter and 11.3% for the fourth quarter of 2009. The quarter over quarter effective tax rate decrease was mainly due to a reversal of tax provisions for the first three quarters of 2010 by a certain subsidiary of NetEase when it became tax exempted for fiscal year 2010 during the fourth quarter of 2010. The year over year effective tax rates remained relatively stable.

Now, turning to fiscal year 2010 financial results. Gross profit for fiscal year 2010 was RMB3.7 billion or $551.9 million, compared to RMB2.8 billion for the preceding fiscal year. The increase in gross profit for fiscal year 2010 was primarily driven by increased revenue, partially offset by increased cost of revenue from the online game and advertising service businesses.

Total operating expenses for fiscal year 2010 were RMB1.2 billion or $176.4 million compared to RMB761.1 million for the preceding fiscal year. The increase in operating expenses in 2010 was primarily due to increased sales and marketing expenses comprising marketing and promotional activities for Fantasy Westward Journey, Tianxia II and Heroes of Tang Dynasty, and increased commissions and other performance based compensations, as well as increased staff related costs resulting from increased head count in general and administration and research and development areas.

Net profit for fiscal year 2010 totaled RMB2.2 billion or $338.8 million, compared to RMB1.9 billion for the preceding fiscal year. For fiscal year 2010 we reported a net foreign exchange loss of RMB89.5 million or $15.6 million under other net, compared to a net foreign exchange gain of RMB9.6 million for the preceding fiscal year.

The change to a net foreign exchange loss for 2010 as compared to 2009 was mainly due to the translation loss arising from our euro denominated bank deposit balances as of 31 December, 2010, as the exchange rate of the euro against the RMB fluctuated over the period. We reported basic and diluted earnings per ADS of $2.61 and $2.60 for fiscal year 2010 respectively. This compares to basic and diluted earnings per ADS of $2.17 and $2.16 for the preceding fiscal year respectively.

We recorded a net income tax charge of RMB344.4 million or $52.2 million and RMB313.9 million at an effective tax rate of 13.4% and 14.6% for fiscal years 2010 and 2009 respectively. As of 31 December, 2010, our total cash and time deposit balance was RMB9.5 billion or $1.4 billion compared to RMB7 billion as of 31 December, 2009. Cashflow generated from operating activities was RMB901.5 million or $136.6 million for the fourth quarter of 2010 compared to RMB532.6 million and RMB712.4 million for the preceding quarter and the fourth quarter of 2009 respectively.

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

Thank you, Sir. Ladies and gentlemen 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.

Hello. This is Timothy [Chan] on behalf of Richard Ji for Morgan Stanley. Hi William, Onward and Brandi. Good morning. Thanks for taking my questions and congratulations on a very robust quarter. My first question is about your gaming pipelines. Could you please kindly update us on the progress of StarCraft II as well as the latest expansion pack of World of Warcraft? When are they likely to be launched in China? Specifically, if I can ask about the revenue model of StarCraftII, that would be great. Thank you very much.

(interpreted) To summarize the highlights bring about by William just now, first of all with regard to our gaming pipelines for our self-developed games, basically in March of this year there will be a testing for our Westward Journey Genesis game titles, whereas in April of this year [the Ghost], another game, was also undergoing further customer testing. We are now undergoing the preparations of the hardware that require installations, and so far the feedback that we've received from the customers has been satisfactory.

As for the launch of the latest expansion packs for the World of Warcraft or the StarCraft II, I think basically we are undergoing the necessary government regulatory review and doing the required content provisions as and when required. For the latest update on the launch of the various game titles, please stay tuned with our official announcement on our official website. Thank you.

Thank you. May I ask if StarCraft II is a [time] based model?

(interpreted) With regard to the business model of the StarCraft II, I think at this stage we are still under the considerations and further updates will be provided. Please stay tuned with our official announcement.

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

(multiple speakers)

Okay, thank you. Mainly two questions. One is regarding the game business, besides the existing the RPG and then (inaudible) business, well we don't think about development games based on other type of, sort of a game type. Like say, for example, the FTS or other kind of like I think the ACG titles.

The second question is related to the e-commerce side. It seems to be the Company has been relatively aggressive promoting (inaudible) business side related on IT because, you know, other kind of new channels recently. Can you explain a bit more about your expectation on e-commerce business going forward?

(interpreted) Just to recall the major highlights by William, with regard to Wallace's first question, I think for whatever new game types that we are going to put into the market, each of those will have its own particular supporters or audiences or the players like, and so it really varies among different types of games. In terms of developing whatever new types of new games in the market, there will be two points that we would be considering.

First, whether the market or the potential market is big enough that we would consider it worth to do, and the second one is that we would see whether we have those kind of development capabilities in developing such kind of, or such type of games. We have been developing games for a very long time and our development philosophy is always two-fold -- one would be customer driven, and second one would be the availability of our internal resources to develop those kind of games.

With regard to Wallace's second questions about the e-commerce, I think this will be another new try for NetEase, and because NetEase has a very good customer base then we would like to take on these advantages to have those companies or the traders to help sell stuff like the air tickets, insurance and stuff like that. Thank you.

Thank you. Just a quick follow-up question on my e-commerce question. Basically (inaudible) also recently have launched an online payment system. Can you give - is it similar kind of like reasons, like just want to have a trial and not necessarily promote it very proactively?

(interpreted) I think basically with regard to Wallace's questions regarding our (inaudible) service, I think basically this would be somewhat different from the e-commerce kind of stuff but this would be the area that we would try our best to improve the technology, and in order to serve our electronic merchants better because there would be a - just similar to the relationship with the banks and the merchants, and this would be another kind of media or channels to facilitate the business transactions using this kind of tools or service. Thank you.

Thank you very much.

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

Good morning. Congratulations on the strong quarter. Two questions -- first of all, can you comment on the advertising demand environment you see for 2011? How much pricing increase would you expect for this year and which advertising category you actually expect to show strong demand this year?

In answering your questions regarding the forthcoming advertising demand in 2011, I think basically we still hold a positive will about this demand in various centers, because we will see that the general economic conditions in China is still quite positive, and given the fact that our internal organizational structure's improvement, better marketing strategies and high recognitions of using the advertising portals as a very effective means to do advertisements or marketing programs for the advertisers, we still believe that this would have a reasonable growth in 2011.

With regard to the various categories that we will still be working on more significantly in the advertising businesses, I think up to now we would still (inaudible) that has been contributing much of the revenues in this part of the business, including the automobiles, internet services, the consumer electronics, apparels, food and beverages, and the like.

I see, great. Second question, can you elaborate a little bit what type of new product applications you are actually planning to launch for the mobile phone? Thank you.

(interpreted) I think basically with regard to our strategies on the mobile phone applications, I think this - we would still regard it would be a very promising area to further explore on, and the companies would be undergoing considerations and put forward some new stuff accordingly.

Okay, can I follow up on one last questions on - we'd like to get William's view on the (inaudible) applications and what are NetEase's strategies on this?

(interpreted) With regard to our (inaudible), I think for NetEase we would put a very high importance on this product, and for our strategies, I think we would try our own strengths to position ourselves in this market and try to give a different kind of user experiences to the users of this tools or services.

Thank you.

Thank you. Our next question's from the line of Dick Wei with JP Morgan, please go ahead.

Hi, morning, thanks for taking my call. Two questions -- the first is I wonder if William can talk about the outlook for the game market for this year. For example, will the game market be growing faster than last year? Secondly is on the video content investment -- will NetEase increased their video content investment this year?

(interpreted) With regard to Dick Wei's first questions regarding the outlook of the game market in 2011 versus 2010, basically the how big or how small the markets would be for the gaming markets would really depend and are highly correlated with the qualities of the product that would be available in the market, and for NetEase we would believe that if there are actually some good products in place in the market then we believe the customers or the players would be more willing to spend, whereas if they would not be any good quality products or the quality of the product is not as good as expected, then in fact the players or the customers would reduce their spending, and would also change their customer behavior alike.

For the second question regarding the video content investment for NetEase, NetEase would also focus on this part of the investment and we believe that by putting through some good educational or cultural kind of content domestically, it would set up or build up a very good platform to educate the users of the websites in general, and somehow this is not a question of how much money or whether or not we are making money from those but we also focus the importance of doing some meaningful educations into the users of the web in general in China. Thank you.

Thank you. Our next question comes from the line of Eddie Leung with Merrill Lynch. Please go ahead.

Hi, good morning and good evening to William, Onward and Brandi. I have a couple of questions. The first one is on your advertising basis. I'm wondering could you comment on the seasonality on your advertising basis for the first quarter of this year, because we have seen quite some fluctuations in the previous years, and given the Asian gains in fourth quarter last year, should we expect like a higher than average negative seasonality in the first quarter for advertising? Thanks.

Okay, with regard to the seasonalities of the advertising business, I think basically from what we observed so far it would be that for the first two - for the first quarters of this year, this would be comparatively it would be a low season because of the Chinese New Year holiday and things like that, but progressively as we are moving through the year to the second, third and fourth quarters of the year, then definitely there would be a progressive trend in building up the advertising business like.

Although we have the Asian games that happened just now in the fourth quarters of 2011, I think we would still see that the general economic conditions in the China is quite positive and we are still working on that and see how it goes.

I got that, and then my second question is on World of Warcraft. Have you guys seen any impact from the Taiwan operator after they launched the new expansion pack on your business? Thanks.

(interpreted) With regard to the questions regarding the impact of launching the new expansion packs by the Taiwan operators, I think basically we do feel that the new expansion packs would attract the players somehow, and we do expect to go through and complete the relevant government review and approval process, and launch the games as soon as possible. Of course, please stay tune with our official announcements on the progress of this.

Got that. I am just wondering could you give us some guidance on the tax rate for 2011? Thanks.

Okay, with regard to the tax rate for 2011, because as you know we have already passed the three year's time for getting the (inaudible). Starting in this year we would be undergoing a new round of applications again, and before we actually get the final approval from the tax bureau regarding the higher new technology (inaudible) status, I think in the meantime we would suggest you to refer back to the standard tax rate for the time being.

Thank you.

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

Hi. Thank you very much for taking my question (spoken in Chinese). So my first question is do you consider raising the pricing for your time-based games in an inflationary environment?

So we do not have any plan of raising the price for our time-based games for the time being.

Okay, thanks for that. My second question is I want to hear about your overall strategies in the Chinese internet industry such as social networking, search and mobile internet (spoken in Chinese). That would be great. Thank you.

(interpreted) I think basically with regard to the overall strategies in the internet industry including the social networking - whether it is social networking, search or internet mobile, internet - I think the more important point is whether we can actually do a good job on our fundamentals and whether we actually deliver good quality products to the market to serve the needs of the various customers or to take the needs of various demands in the market.

One very good example of that is Westward Journey Online II. This one is a product in place for over eight years and still you will see that in the fourth quarters of 2010 from the [revenue] perspective we have created a new hit record or a new high in terms of the revenues.

What this means is that we actually (inaudible) in making sure that our product is of the highest qualities in servicing our customers or players alike. Then we would get the necessary recognitions from the customers in return. This is also one of the visions or the philosophies that we always advertise within the NetEase family, that for whatever new product that we are going to launch in the market we need to make sure that the quality is of the highest one to serve the market. We believe in return we will get the recognition from the market and the players or customers alike. Thank you.

Thank you very much, congratulations.

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

Good morning, everyone. Thanks for taking my question. My first question is, well if we look at the US, World of Warcraft Cataclysm was launched about two years after Wrath of the Lich King. So William just mentioned we will try to publish it as soon as possible. But my question is, do you think actually players might want more time to experience Wrath of the Lich King before Cataclysm actually changes the whole game world? So just get your thoughts.

Are you trying to launch the game right after you get the approval, assuming that's possible, or do you think players might actually want more time to play Wrath of the Lich King before Cataclysm?

(spoken in Chinese)

Onward, do you want to translate?

Hello?

Do I need to wait for a translation?

Yes, could you just repeat one more time.

Yes, because we have lost line just now.

You lost the connection?

I got an answer in Chinese, but do we need to translate it?

I think (spoken in Chinese).

(interpreted) Basically, with regard to the launch of the new expansion packs for World of Warcraft, in particular the Cataclysm, as soon as we get the necessary approval from the government authorities, we will launch the games very soon.

Thanks. My second question is very quickly just on the business tax rates - it seems that it's quite low, much lower than previous quarters. With the exception of just a revenue mix of self-developing and licensed games, are there actually any changes for respective segments in business tax rates in this quarter for games?

I think, basically, we are still following our existing plan of executing our products, and there has been no major change in the tax rate or what.

So why is that so low this quarter?

I think because - I think for different kinds of games or business models, because they were following different sets of rules and regulations that we have been following and a different kind of - what I would say is that we would say that the change in the business tax rates may be a result of the mix of both the (inaudible) and also the licensed games. But there hasn't been any major changes in other factors.

I see. Thank you very much.

Okay, thank you.

Thank you. Our next question comes from the line of Adam Krejcik with Roth Capital Partners. Please go ahead.

First, for World of Warcraft, I believe you started offering a service that allows players to pay to switch servers. I was just wondering if you could comment on what the feedback for that service was in the fourth quarter, and then if there's any other type of premium or value added services you plan to add like that in 2011. Thanks.

(interpreted) I think, basically, in terms of the user feedback from the existing paying models, I think the response from the players is also very positive. With regard to the value added services, I think we will launch as and when we see fit. Basically, so far, what we have been launched would be something like (inaudible) kind of value added services. For any additional new kind of value added services, please refer to the latest announcements on our official website.

Okay. And then quickly, just in terms of online advertising, in 2010 there was the Shanghai Expo, the World Cup, and the Asia Games in the fourth quarter. I was wondering if there's any big events we can look to in 2011 that you plan to sponsor and, if not, will this impact growth on a year-over-year basis for your online advertising business?

Okay. I think, basically, although there have been a few big events that happened in 2010, which also received very good returns or feedback from the advertisers, we still look forward that the general economic conditions in China is still positive for 2011.

At this stage, of course, we do not have any other specific events to announce regarding other kinds of sponsorship, but we still (inaudible) positively about the growing trends in the advertising business segments, owing to the fact that we also have very strong sales execution teams, improving the internal organizational structures, better marketing strategies, and also better recognition by the advertisers of using the advertising portals as effective means to do the advertising and promotional events and activities.

Thank you very much and congratulations on a good quarter.

Okay, thank you.

Thank you. At this time, I'd like to turn the conference back over to Ms Piacente for any closing remarks.

Thank you again for joining us today. If you have any questions, please feel free to contact us. Thank you.

Thank you, ladies and gentleman. If you'd like to listen to a replay of today's conference, please dial 1800 406 7325 or 303 590 3030 using the access code of 4406810 followed by the pound key. This does conclude the NetEase fourth quarter 2010 earnings call. Thank you very much for your participation. You may now disconnect.

Portions of this transcript that are marked (interpreted) were spoken by an interpreter present on the live call. The interpreter was provided by the Company sponsoring this Event.