NetEase Inc (NTES) 2011 Q1 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the NetEase first quarter fiscal 2011 earnings conference call. (Operator Instructions)

At this time I'd like to turn the conference over to 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 government liability as established by the US Private Securities Litigation 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.

(interpreted) Thank you Brandi. Before I begin, please note for the purposes of this discussion all percentages are based on Renminbi.

For the first quarter of 2011 total revenues increased at 29% year over year, and decreased 8% quarter over quarter to RMB1.5 billion or $234.9 million. Revenues from online games increased at 28% year over year, and decreased 3% quarter over quarter to RMB1.4 billion or $211.6 million for the first quarter of 2011.

The strong year over year revenue growth was primarily driven by high revenue contributions from our self-developed games; namely Heroes of Tang Dynasty, Fantasy Westward Journey, Westward Journey Online II and TianXia II, along with continued revenue growth from World of Warcraft, a game licensed from Blizzard Entertainment. The quarter over quarter decrease in online games revenue was mainly due to seasonality.

Fantasy Westward Journey and Westward Journey Online II continued to perform well during the first quarter. This was due to well-received promotional campaigns during the period, along with favorable response to the latest expansion pack for Fantasy Westward Journey released in January 2011.

As a game, in its eighth year of commercial operations, we were tremendously pleased with Westward Journey Online II's new record quarterly revenue in the current quarter, as well as a new record number of peak concurrent users achieved as a result of players' positive response to promotional activities held during the recent Labor Day holidays in China. We plan to keep working hard to make the game a continued success.

Our newest self-developed games; Heroes of Tang Dynasty and TianXia II, also continued to show solid growth during the first quarter. We concluded the open beta test for Blizzard Entertainment's StarCraft II in China during the first quarter, and commenced its commercial operation on April 6, 2011.

StarCraft II holds for - holds the record for fastest-selling strategy game of all time, and we are delighted to bring this exciting game experience to Chinese players.

A new expansion pack for TianXia II was released in April, with the next schedule for launch during the game's second year anniversary in September 2011.

Genesis are scheduled for release during the third quarter of 2011.

In view of the outstanding user statistics performance during the limited closed beta testing for Ghost in the first quarter, we started the unlimited closed beta testing for this game in April and also plan to launch its next new expansion pack in the second half of 2011.

Our new 2.5D turn-based MMORPG, Legends of Fairy just entered limited closed beta testing in early May. In this game, players can enjoy an exciting and adventurous journey in a European-styled fantasyland. Unlike traditional online games, this new game allows players to freely change characters, skills and attributes allowing for evolving combat experiences as the game progresses. We plan to proceed with its unlimited closed beta in the second half of 2011.

Now turning to advertising and portal activities. First quarter revenues from advertising services grew 39% year over year and decreased 46% quarter over quarter to RMB126.8 million or $19.4 million. The year over year increase in advertising services revenue was attributable to increasing demand for advertising services, particularly from the automobile and Internet services sectors which were our top performing sectors for the quarter. The quarter-over-quarter revenue decline from our strong fourth quarter 2010 reflects typical industry seasonality and a non-recurring impact from our 2010 Asian Games sponsorship.

During the first quarter of 2011, we were pleased to launch our newly developed mobile news application software for smart-phones which instantly became a top applications download. We remain committed to addressing advertisers' growing demand by offering unique contents innovations, service integrations and new product development.

This concludes William's updates on games, advertising and portal. Now I will provide a review of our first quarter 2011 financial results. I will primarily focus on the discussions of margins and expense fluctuations along with net profit.

Gross profit for the first quarter of 2011 was RMB985 million or $150.4 million, compared to RMB1.1 billion and RMB772.4 million for the preceding quarter and for the first quarter of 2010 respectively. The quarter over quarter decrease in gross profits was primarily due to the decrease in revenues from advertising services and online games, partially offset by decreases in information costs and incentive compensations resulting from decreased advertising services revenue. The year over year increase in gross profit was primarily attributable to increased revenues from both the online games and advertising businesses, partially offset by increasing cost of revenues from the online games business.

Gross profit margins, for the online game business, for the first quarter of 2011 was 70.0% compared to 71.8% and 71.9% for the preceding quarter and the first quarter of 2010 respectively. Gross profit margin for the advertising business for the first quarter of 2011 was 33.4%, compared to 53.5% and 16.9% for the preceding quarter and the first quarter of 2010, respectively. The quarter over quarter decrease in gross profit margin was mainly due to the significant decline in advertising service revenue, partially offset by lower cost of revenue in the current quarter for reasons explained.

The year-over-year increase in gross profit margins was primarily due to increased advertising service revenue, partially offset by increased revenue sharing costs and staff related costs, resulting from increased headcounts during the first quarter of 2011.

Gross loss margin for the wireless value added services and others business for the first quarter of 2011 was 21.6%, compared to 19.7% and 35.9% for the preceding quarter and the first quarter of 2010 respectively.

Total operating expenses for the first quarter of 2011 were RMB292 million or $44.6 million, compared to RMB320.7 million and RMB217.4 million for the preceding quarter and the first quarter of 2010 respectively. The quarter over quarter decrease in operating expenses was primarily due to reduced selling and marketing expenses, resulting from reduced marketing promotional activities for certain self-developed games and World of Warcraft.

The year over year increase in operating expenses was primarily due to increased selling and market expenses related to Westward Journey Online II, Heroes of Tang Dynasty and Ghost and increased staff-related costs resulting primarily from increased headcount in the general administration and research and development areas.

In addition, share-compensation costs grew by RMB20.4 million year-over-year, resulting mainly from restricted share unit awards first granted by the Company in June 2010.

Net Profit for the first quarter of 2011 totaled RMB737.4 million or $112.6 million compared to RMB712.5 million and RMB452.3 million for the preceding quarter and the first quarter of 2010 respectively.

During the first quarter of 2011, we reported a net foreign exchange gain of RMB25.3 million or $3.9 million, compared to net foreign exchange losses of RMB36.4 million and RMB39.5 million for the preceding quarter and the first quarter of 2010, respectively. The quarter-over-quarter and year-over-year foreign exchange gains and losses were mainly due to the translation gains and losses arising from the Company's Euro-denominated bank deposit balances as of March 31, 2011 as the exchange rate of the Euro against the RMB fluctuated over the periods.

We reported basic and diluted earnings per ADS of $0.86 each for the first quarter of 2011. This compares to basic and diluted earnings per ADS of $0.84 and $0.83 for the preceding quarter respectively; and $0.53 each for the first quarter of 2010.

We recorded a net income tax charge of RMB37.2 million or $5.7 million for the first quarter of 2011, compared to RMB83.2 million and RMB94.5 million for the preceding quarter and for the first quarter of 2010, respectively. The effective tax rate for the first quarter of 2011 was 4.8% as compared to 10.3% for the preceding quarter and 17.4% for the first quarter of 2010.

Our various principal subsidiaries' enjoyed the preferential enterprise income tax rate of 15% as High and New Technology Enterprises from 2008 to 2010. These subsidiaries are currently in the process of applying to renew the New and High Technology Enterprises qualifications and expect to be able to retain these qualifications for 2011 to 2013 as the qualifications criteria remain unchanged.

Accordingly, this preferential tax rate has been applied for these subsidiaries our estimated annual effective tax rate for 2011, though we caution that it cannot be certain such applications will be approved. The quarter-over-quarter decrease in effective tax rate was mainly due to the recognitions of a tax benefit of approximately RMB47.1 million or $7.2 million related to fiscal year 2010 upon receiving the Key Software Enterprises status during the first quarter of 2011.

The year-over-year decrease in effective tax rate was mainly due to the above-mentioned tax benefit. In addition, one our other subsidiaries was recognized as a Software Enterprise in the fourth quarter of 2010 resulting in tax-exempt status for 2010 and 2011.

Turning to the balance sheet, as of March 31, 2011, our total cash and time deposit balance was RMB10.4 billion or $1.6 billion, compared to RMB9.5 billion, as of December 31, 2010.

Cash flow generated from operating activities was RMB969.3 million $148 million for the first quarter of 2011, compared to RMB901.5 million and RMB676.5 million for the preceding quarter and the first quarter of 2010, 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.

As a reminder, if you do have a question please press the star followed by the one on your touch-tone phone. If you'd like to withdraw your question, please press the star followed by the two. If you're using speaker equipment today, please lift the handset before making your selection.

The first question is from the line of Richard Ji with Morgan Stanley, please go ahead.

Oh hi William and Onward, good morning. Thanks for taking my call.

Let me start with two questions. First, looking to your pipeline you have a very robust pipeline and we're very curious about the new developments for some of the new game categories such as battle based StarCraft as well as the web based games. Can you comment on the new development in those categories - and especially how you differentiate I think it's called hardcore MMORPG games?

Can you also comment on your current thinking about advanced casual games as well as the mobile games which may also present tremendous growth opportunities going forward?

Just now, William has highlighted his views on behalf of the Company about the new development on the battle game StarCraft II and also the web games.

(interpreted) First of all we guarantee better (inaudible) games. In fact StarCraft II is the second game that we have rolled out on this platform; and in fact for net use we have two games currently being operated on this platform - namely World of Warcraft and the other one is StarCraft II.

To think about our new products roll out, in particular there's StarCraft II. We would like to highlight that StarCraft II is not simply just a real time strategy game, but in fact it's also a very good platform offering different people to develop some new game types or new features to play. So this will be a special highlight that we would like to bring about.

As for the web game development for net use, I think up to now the qualities of our products roll out has been greatly enhanced and strengthened in the market. So far, based on the useful feedbacks from our casual base we also got some very good responses there from. To - if you've heard some about our new game roll out, in fact we have planned to roll another new web game next month which - in the coming months - which has been developed for over two years. The game is called Fairly Land which we think has got a very good response accordingly.

Regarding Richard's second question on the Company's will on the development of the advanced casual games and also the mobile games, definitely from a NetEase perspective, we do place great importance on the developments on this front.

But if we are talking about the mobile games development at this stage, owing to the fact that we do not see a very clear or specific way of monetizing the games, I think at this stage we do not have greater updates to bring up at this point.

Thank you William, that's helpful.

Thank you.

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

Hi, thanks for taking my questions.

I have two questions. First question is on the social network site. I wonder any update on the social network?

My second question is what kind of seasonality we saw in Q1 - which games saw more impact - more from the seasonal impact?

Maybe I just recap the main points that have been responded by William just now on these questions.

(interpreted) Regarding the Company's strategy on the F&S Site, basically NetEase places very high importance on the rollout of the micro-blog product. But at this stage still we do not have a very clear sense or specific view on how good and how effective this product could have to monetize. This would be an area that we would further think about.

At the same time we also see that on the micro-blog service the current competition is still very intense. But having said that it would not hinder our efforts to further roll out this product and we will still continue on rolling out this product to the market.

Regarding the second question on the Q1 seasonality on the games; basically I think because of the fact that by now we have quite a lot of games permanently operated and in play in the market, we still need to get that loaded into our information and see how we could provide you further details afterwards. Thank you.

Thank you.

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

Hey, good morning William and Onward. Just a two part question; the first one is regarding your gross margin. Are you concerned that the gross margins of your online game business seems to have declined quarter with quarter in the first quarter? So I'm just wondering number one, what would be the reasons for that; and number two, how should we look at the gross margin of the game business in the coming couple of quarters. That would be my first question.

The second question is to clarify something. I remember Onward you mentioned that TianXia II had potential to post growth in the first quarter. Are you referring on the quarter for quarter basis or the year on year basis?

Then my other question is regarding you market expenses. It declined in the first quarter, so just wondering how should we think about it in the second quarter. Yeah, that's about it thanks.

William maybe I will take your questions from Eddie Leung regarding the various questions.

First of all regarding the gross margins, the slight drop quarter over quarter is mainly because there has been some seasonality impact; and also there has been some additional royalties and consultancy fees as well given out which has certain impacts on the gross margins.

But going forward based on the current situations I think the current levels of the gross margin would be the kind of levels we are looking at to keep and maintain.

Regarding your second question - regarding the increase in the performance of the - you mentioned TianXia II but in fact it is not the TianXia II but the Heroes of Tang Dynasty. The other one should be TianXia II. But I think basically for the previous quarter I think we have been also performing quite healthily and stable from what we have said so far.

Regarding the marketing expenses, I think based on the current levels of the marketing expenses that we have incurred for the first quarter, just as we have previously mentioned, the Company will also continue that. Now it would be an appropriate time to make a corresponding increase in the marketing spending to cope with the development of our various products.

We will also see that we will upkeep the current levels and perhaps increase according to various commercial events and activities that we would have during the upcoming quarters.

Okay that's very helpful thanks.

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

Thank you. Good morning. Thanks for taking my questions. I have first a question on the departure of the COO. I understand it's personal reasons but would you be able to tell if the operation will be impacted by his departure. That will be my first question.

The second question is if we look at the business - the online game business is bigger and bigger in the percentage of revenue. The portal business is growing well, but relatively smaller and different businesses. So do you have any plan to carve out the online portal just to make it more independent? Those are my two questions.

Maybe I just recap the main points that were brought up by William just now.

(interpreted) Regarding the first question about the potential impact of the departure of our COO, I think basically the Company is quite regretful on the departure of Mr. Zhan who has been with the Company for almost 11 years.

But having said that we do believe that under the leadership of William in the upcoming period, based on our experiences and our R&B capabilities so far, we will be able to bring our business to the next level which we see being very positive in the upcoming future.

With regard to the second question on the potential carve up of the portal business - basically I think the Company's business philosophy or our strategy is not solely based on how much the revenue it would bring about by certain business factors - in particular the portal business. In fact we do offer a very good free email platform where from time to time we're adding some new features to it; and the number of users has been heavily growing from time to time. So making sure we have a healthy market share as such.

At the same time we still also place importance on the developments of the micro-blog or so-called social networking kind of business development. To supplement what William had highlighted just now I think NetEase as a comprehensive internet technology company that brings to the users of the internet with a wide area of different kind of services that could suit their needs and demand. Thank you.

Thank you very much.

Thank you. Our next question comes from the line of Paul Wuh with Samsung Securities. Please go ahead.

Thank you for taking my questions. Just a couple of quick ones - first on the tax rate. You explained why it was so low in the first quarter. What kind of tax rate do you think we should use for the full year? My second question is on your new web based games. What kind of revenue contribution do you think we can see this year from that and - because I think it's going to be relatively low but I just wanted to find out what you think on that front, that and other casual games? Thank you.

Okay. Regarding your first questions, regarding the anticipated ETR or the effective tax rate for 2011, I think basically at this stage we would advise that you could make reference to what we have been doing in last year as a benchmark. But at the same time I think we have to reiterate that for this year we are still undergoing the renewal of the high newton enterprises test data applications and as soon as we get the approval from the test bureau then the relevant test rates for those qualifying prices will be 15% and this is the way that we will be looking at the ETR for the time being. As regards for the web games contributions, I think at this stage our focus is to make sure that we would develop some good quality games on the web games side to make sure that the game experiences could be established for this part of the market. We would also host a positive view about its long term development potentials.

Okay and one follow up. I just wanted to clarify on the gross margin for the game business. Did you indicate that you expect it to stay around the same level for the rest of the year as you had in the first quarter?

Yes.

Okay, great. Then also on the - I think you mentioned automobile is the - one of the largest categories for advertising. We've been hearing it's slowing down overall from CNN and some of the others that the year over year growth in auto advertising is slowing first from the larger base and also from the fact the auto industry is not doing as well this year. What are you guys seeing so far and what are your expectations?

I think based on our current performance that has been received so far, I think our top performing web groups would still be the automobiles and also the internet services. I think so far this will still be our major performing web groups.

What do they represent as far as percentage of revenue, these two categories?

Because we basically would not give out the break up of our individual sectors revenue contributions but what I can tell you is that out of our total advertising revenues contributions the major contributors would be the automobiles and the internet services.

Right, thank you very much.

Okay, you're welcome.

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

Thanks for taking my question. I would like to ask you if you have any bigger strategy for portal? My second question is regarding your guidance for share based compensation.

First of all, regarding our portal strategies, I think so far we have quite on a right track by having various kind of (inaudible) content and at the same time to make good use of our other service platforms like our microblog and also the e-mail surveys and various kinds of service to make sure that we have a very good projections of our services to the potential advertisers alike. So far in terms of the business development, just as what we have just highlighted just now, our major or top performing web groups would be the automobiles, internet services the like and this will still be the areas that we would be working on. On the other side of this business so far I think the entire advertising business marketing is also growing quite healthily and more and more people would got the high recognitions of using the internet platforms or the portals as an effective means of placing the - of doing some marketing promotion activities, which we believe we will be able to share this kind of positive impact.

On your second question regarding the SBC, I think basically we do not have an exact numbers of what we would be making but at least you could make reference to the current quarter's levels in terms of the dollar amounts as a reference point for projecting in your (inaudible).

Okay, thank you.

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

Hey guys, thank you for taking my call. I have a couple of questions on the Blizzard game. I hoping to understand the seasonality that you talked about in Q1. Have you started seeing some bounce back on Blizzard? And secondly, I was wondering if you can share any update on StarCraft II. Did it meet your expectation? Is it better than your expectation, below your expectation? Any color you can give regarding StarCraft II that would be great. Thank you.

First of all, regarding your first questions regarding the World of Warcraft, I think basically we would not use the terms bounce back but just as what we have highlighted earlier in the earnings call, the performance of the World of Warcraft has been quite on track and even if there has been a little back decrease this would be due to the seasonality issues that we would see. With regard to your second question regarding the StarCraft II performance, I think so far the responses or the feedback that we have got from the players has been quite positive and I believe our current focus will still be making sure that we would try our every efforts to make sure that the users and game experiences would be enhanced and strengthened at all times. Also at the same time we would try our best to establish the communities in those games as well and this would be the current updates that we would like to share with you.

Okay, thank you.

Okay.

That's all the time we have for questions today. At this time I'd like to turn the conference back over to Brandi Piacente for closing remarks.

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

Thank you ladies and gentlemen. 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 4435523 followed by the pound key. This does conclude the NetEase first quarter fiscal 2011 earnings conference call. Thank you for your participation. You may now disconnect.