NetEase Inc (NTES) 2011 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the NetEase second quarter, fiscal 2011 earnings conference call. (Operator Instructions). This conference is being recorded today, Wednesday, August 17, 2011, and I would now like to turn the conference over to Brandi Piacente of 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 from liability as established by the US Private Securities Litigation Reform Act. Such statements are not guarantees of future performance and are subject to certain risks and uncertainties, assumptions and other factors.

Some of these risks are beyond the Company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion. A general discussion of the risk factors that could affect NetEase's business and financial results are included in certain filings of the Company with the Securities and Exchange Commission including its annual report on Form 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.

Before I begin, please note that for the purposes of this discussions, all percentages are based on RMB. For the second quarter of 2011, we achieved total revenues of RMB1.8 billion or $275.1 million demonstrating strong quarter over quarter and year over year growth across our online games and advertising services business segments.

For the second quarter of 2011, our online games revenues were RMB1.6 billion. This represents a 13.9% sequential quarter increase and an increase of 33.6% year over year. Our sequential quarter increase was driven by our newly launched self-developed game, Ghost, as well as continued demand for Fantasy Westward Journey and World of Warcraft, again licensed from Blizzard Entertainment.

Our year over year online games revenue increase was also mainly due to the growth in our self-developed games including Fantasy Westward Journey, Ghost, Westward Journey Online II, Tianxia II and Heroes of Tang Dynasty along with continued revenue growth from World of Warcraft.

In addition to these achievements, during the same quarter, we released our latest expansion pack for Westward Journey Online II which introduced new features and expanded content as well as the return of extensible characters with exciting new appearances.

Since the launch of this expansion pack in May 2011, the user statistics have been quite healthy. We are extremely pleased with the performance of this game and based on these additions, we achieved new record revenue and PCUs for Westward Journey Online II in the same quarter.

During the quarter and in recent months, we also made several other key additions to further expand our robust volume of online games. I would like to highlight a few of these at this time.

First, we initiated unlimited closed beta testing of our self-developed game, Ghost, in April. The user statistics performance for this game has been outstanding. Players have widely praised Ghost for its quality and we plan to launch a full scale closed beta testing in the second half of 2011.

Second, we successfully launched open beta testing in June for Heroes of Tang Dynasty and are pleased with the revenue and user statistic tests generated so far. In April we introduced StarCraft II for the first time to the Chinese market, again licensed from Blizzard Entertainment.

We've received a lot of favorable feedback and recently launched marketing promotions in China that yielded some positive results. We also launched the StarCraft II starter additions on August 2 which gives players who have never tried StarCraft II a chance to play one of the world's most popular and critically acclaimed RTS games for free.

In July we launched the highly anticipated World of Warcraft Cataclysm, the third expansion set for Blizzard Entertainment's award winning MMORPG. World of Warcraft is the largest subscription based MMO in the world and continues to remain popular in China. So far we are pleased with the warm response we have received from the Chinese players since Cataclysm's launch.

For the second half of 2011 we plan to continue to enhance the contents of our existing games where we see the opportunities to optimize the user's experience while continuing to invest in complementary sales and marketing activities. Specifically in the second half of this year, we plan to launch expansion packs for Fantasy Westward Journey, Westward Journey Online III and Legend of Westward Journey, which we are renaming Warsong of Westward Journey. In addition we are preparing to release a comprehensive upgrade for Tianxia II and we are continuing to enhance the contents for Ghost prior to its full scale closed beta testing launch which is planned to commence in the second half of the year.

Turning to our advertising and portal activities. Advertisers are increasingly appreciating our content innovations, service integrations, new product developments and our portal's strong and growing appeal to users. These attractive qualities are driving growth of this business segment. During the second quarter, our advertising services revenue grew to RMB169.6 million or $26.2 million representing a 33.8% quarter over quarter increase and a 16.2% year over year increase.

It is usual for advertisers to increase their spend in the second quarter compared with the first quarter. We have experienced growing demand for advertising services from internet services, food and beverage product and financial services sectors.

We are also seeing great success with our e-mail and micro-blogging platforms. Our mailbox services and micro-blogging products are getting broad acceptance in China's rapidly growing mobile internet market. Growing these strategic portions of our business has been among our top initiatives. During the second quarter we grew our mail users - by nearly 40% on a sequential quarter basis - to 410 million and the total number of registered micro-blogging users increased by approximately 33% to 52.5 million.

During the period, we invested in significant upgrades to our mobile infrastructures and engaged in exciting promotional activities to help drive user tractions including advertising on high profile television shows and collaborating with major mobile phone manufacturers to install our mail services on their mobile devices.

With our micro-blogging services, we launched two new micro-blogging products, Micro-debate and Micro-event as well as upgraded our micro-blogging life homepage to provide more valuable content to our users. We also hosted the first Micro Movie Festival in China. As our mobile business evolves, we plan to leverage this growing user base to further expand our market share, grow our portfolio of industry leading online games and increase our advertising services revenue.

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

Gross profit for the second quarter of 2011 was RMB1.2 billion or $178.4 million compared to RMB985 million and RMB870.9 million for the preceding quarter and the second quarter of 2010 respectively. The quarter over quarter increase in gross profit was primarily attributable to the increase in games revenue from our self-developed games, Ghost, Fantasy Westward Journey, as well as World of Warcraft and increased advertising service revenue, partially offset by the increased costs of revenues.

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 increased costs of revenues related mainly to the online games business. Gross profit margins for the online game business for the second quarter of 2011 was 70.2% compared to 70% and 71% for the preceding quarter and the second quarter of 2010 respectively.

Gross profit margins for the advertising business for the second quarter of 2011 was 43.9% compared to 33.4% and 43.3% for the preceding quarter and the second quarter of 2010 respectively. The quarter over quarter increase in gross profit margin was mainly due to economies of scale as advertising [directly] increased in the second quarter without a corresponding increase in advertising related costs.

Gross loss margins for the WVAS and others business for the second quarter of 2011 was 7.8% compared to gross loss margins of 21.6% and 40.2% for the preceding quarter and the second quarter of 2010 respectively. The improved gross loss margin for our WVAS and others business in the second quarter of 2011 was mainly due to increased revenues from our e-commerce business and mailbox services.

Total operating expenses for the second quarter of 2011 were RMB365.8 million or $56.6 million compared to RMB292 million and RMB261.3 million for the preceding quarter and the second quarter of 2010, respectively. The quarter-over-quarter increase in operating expenses was primarily due to increased selling and marketing expenses, resulting from increased marketing promotional activities for Heroes of Tang Dynasty and Ghost. This increase was partially offset by decreased general and administrative expenses, mainly resulting from the reversal of share-based compensation costs and accrued bonuses relating to the resignations of a senior executive and certain staff in the second quarter of 2011.

The year-over-year increase in operating expenses was primarily due to increased selling and marketing expenses related to the increased promotional activities as mentioned above, and increased staff-related costs, resulting primarily from increased headcount in the research and development areas. In addition, share-based compensation costs decreased by RMB13.7 million year over year, resulting mainly from the reversal of the previously referenced share-based compensation costs.

Net profit for the second quarter of 2011 totaled RMB772.5 million or $119.5 million, compared to RMB737.4 million and RMB485.7 million for the preceding quarter and the second quarter of 2010, respectively.

During the second quarter of 2011, we reported a net foreign exchange loss of RMB3.0 million or $0.5 million, compared to a net foreign exchange gain of RMB25.3 million and a net foreign exchange loss of RMB67.8 million for the first quarter of 2011 and the second quarter of 2011 (sic), 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 our Euro-denominated bank deposit balances as of June 30, 2011 as the exchange rate of the Euro against the RMB fluctuated over the periods.

We reported basic and diluted earnings per ADS of $0.92 and $0.91, respectively, for the second quarter of 2011. This compares with basic and diluted earnings per ADS of $0.88 and $0.87, respectively, for the first quarter of 2011 and basic and diluted earnings per ADS of $0.58 each for the second quarter of 2010.

We recorded a net income tax charge of RMB92.4 million or US$14.3 million for the second quarter of 2011. This compares with RMB37.2 million and RMB75.5 million for the preceding quarter and for the second quarter of 2010, respectively. The effective tax rate for the second quarter of 2011 was 10.9%, compared to 4.8% for the preceding quarter and 13.4% for the second 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 High and New Technology Enterprises qualification and expect to be able to retain this qualification for 2011 to 2013 as the qualification criteria remain unchanged.

The quarter-over-quarter increase in the effective tax rate was mainly due to the recognition of a tax benefit of approximately RMB47.1 million related to fiscal year 2010 upon two of our subsidiaries receiving Key Software Enterprises status during the first quarter of 2011. The year-over-year decrease in the effective tax rate was mainly due to one of our other subsidiaries being recognized as a Software Enterprise in the fourth quarter of 2010 resulting in tax-exempt status for 2010 and 2011.

Turning to our balance sheet, as of June 30, 2011, our total cash and time deposit balance was RMB11.1 billion or $1.7 billion, compared to RMB9.5 billion, as of December 31, 2010. Our total held-to-maturity investments balance was RMB168.9 million or $26.1 million as of June 30, 2011. There were no such investments as of December 31, 2010.

Cash flow generated from operating activities was RMB995 million or $153.9 million for the second quarter of 2011, compared to RMB969.3 million and RMB744.3 million for the preceding quarter and the second quarter of 2010, respectively. Thank you for your attention. We will now be happy to take your questions. Operator, please go ahead.

(Operator Instructions) Our first question comes from the line of Timothy Chan from Morgan Stanley. Please go ahead.

Good morning, William, Onward and Brandi. Thanks for taking my questions. Let me congratulate you on the very solid quarter. My first question is regarding SNS and [waveup] audits. How should we understand the Company's strategy in that area and how would these services leverage on NetEase's [sominent] email community? I have a follow up question after that, thank you.

Okay, I think your questions would be surrounding the [stranges] on our micro-blogging and the other one is (multiple speakers)

SNS and waveup audits.

(Spoken in Chinese)

I think basically as we recap on the highlights of William on our SNS and micro-blogging strategies. First of all we do, from the Company's perspective, we do appreciate that NetEase has been doing very well especially in the online game products which we receive a well response from the market and also the users and players alike. By now, we do appreciate that the micro-blogging is a new trend and we would take into our existing strengths and capabilities to further make some good information integration capabilities to further leverage these strengths, to further put forward our micro-blogging businesses. We do also think that the micro-blogging business has a good potential for further developments. Thank you.

Thank you very much. I have a second question. This is regarding your online media strategies. Will you be focusing on more licensed contents or in-house developed contents like micro movies? Thank you.

(Spoken in Chinese)

Okay, with regard to the Company's strategies on the online video developments and also the micro movies strategies, I think basically the Company is currently progressively identifying the opportunities to develop in this area. Also for the micro movie strategies, we are also taking the same strategies by progressively identifying new opportunities to further develop it.

Thank you very much, that's very helpful.

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

Hi, morning. Thanks for taking my questions and congratulations on a very good quarter. William I have two questions. Let me ask this in Mandarin first (spoken in Chinese)

(Spoken in Chinese)

(Spoken in Chinese)

(Spoken in Chinese)

Okay, maybe I will just get a quick recap on the highlights of what William has highlighted about the Company's mobile internet strategies and perhaps some of the new types of games introduction to the market such as the web games or the social games that Wallace has just highlighted. For 11 new products that the Company is going to introduce in the market NetEase will achieve our ongoing and existing serious and cautious review in developing and researching the new products before we put forward any new things to the market.

As for the mobile internet strategies in general we do appreciate that the current development is that the IOS platforms being developed by the Apple and the Android platforms will be the main stream for putting forward and developing in this area. In order to tap into this competitive advantage in rolling over the mobile internet in the future we will develop certain products and services alike with our core competencies on those platforms.

We would not consider developing any other kind of platforms ourselves but will make good use of the existing platforms like the Apple IOS and also the Android one.

Yes, thank you.

(Spoken in Chinese)

There is a supplement that William would also like to highlight about the Company's operations and strategies. I believe all of you looked at this quarter's press release we do make a disclosure about our free e-mail users registration numbers which is quite impressive and encouraging. From our free e-mail user service we have already over 10 years history of our service by putting it forward in the market. We have always been receiving a well-received response from the market as well.

While there has been a trend of going to the mobile internet area we will do our very best to extend our services from the existing PC platforms to the mobile platform alike by making use of the Apple IOS and also the Android platforms alike. We also believe that with our current strong user base and good user experiences that has been enjoyed by our users this will also be extended to the new area in the mobile platforms. Thank you.

(Spoken in Chinese) I have just one quick supplementary question. (Spoken in Chinese)

(Spoken in Chinese)

Basically with regard to Wallace's questions on the Company's possibilities of exploring the cloud services going forward, basically the Company does not have any intention of developing the cloud operating systems from a strategic perspective. Also from an engineer's perspective William also believes that this is not the kind of area that we would explore based on the current development profiles.

(Spoken in Chinese) Thank you.

Thank you and our next question comes from the line of Dick Wei from JPMorgan. Please go ahead.

Oh, hi this is Marie asking questions on behalf of Dick Wei. My first question is about your online gaming. As we know you announced the World of Warcraft Cataclysm, in July. May we ask about the user's feedback for this game after this launch?

I think basically--

(Spoken in Chinese)

Basically with regard to your questions regarding the launch of World of Warcraft: Cataclysm in July I think basically while we don't disclose specific regional subscribers data for competitive reasons, the player engagement is going strong. We are still thrilled that the World of Warcraft remains by far the largest subscription based MMO game in the world. We are grateful for the first impressions of our players and we continue to work hard at serving the massive World of Warcraft community in China. Thank you.

Okay thank you. Our second question is about your new game Ghost. It seems that Ghost is doing quite well from the current user trend. Would you expect this game to be one of the top games this year? Thank you.

(Spoken in Chinese)

(Spoken in Chinese)

(Spoken in Chinese)

(Spoken in Chinese)

(Spoken in Chinese)

Okay.

Basically I think William has already given a very direct and positive response to your questions regarding our rollout of the Ghost game itself and we do believe that given the user response and we do believe that this game will be one of our major games for this year.

Okay, thank you it is very helpful. Thank you.

Thank you and our next question comes from the line of Mark Marostica of Piper Jaffray, please go ahead.

Yes congratulations on the quarter. My first question relates to the selling and marketing expenses in the quarter. A consideration of the second half game launches that you have planned, how should we think about selling and marketing expenditures for Q3 and Q4 relative to Q2? Then a related question regarding the operating margins in the back half of the year. I'm just curious how you think those will trend just based on your marketing spend plans? Thank you.

Mark, with regard to your first question on the sales and marketing expenses I think basically the Company will continue our efforts to do more sales and marketing in order to promote our existing service delivery across our gaming products and also our products. You will see that especially in the second quarter there has been a quite significant increase in that respect. This will also be quite aligned with the Company's strategies across the years.

Because usually following the trend the major selling and marketing spending what happens starting from the second quarter towards the third quarter alike. We do believe that this will still be the Company's strategy in order to have a well investment in terms of the sales and marketing expenses in order to further drive our existing revenue generation.

With regard to your second question on the operating margins, I believe that we do always strive to upkeep the existing operating margins in order to cope with the Company's expansion plans. I think up to now the Company has also kept a relatively stable range in terms of the operating margins and we do anticipate that we will try to upkeep this going forward.

Thank you and just another question related to the game pipeline. With regards to your plans for new games later this year and into fiscal '12 I'm wondering if you could comment on providing any color on Diablo 3 if there's any information you can provide us regarding the possibilities for your licensing that game eventually from Blizzard? Then tied to that any color on your fiscal '12 -- 2012 game pipeline would be helpful. Thank you.

I think by far the existing game delivery will be what we will be currently working and especially what we have already highlighted in this quarter's press release. Our major efforts will be working on Ghost and also Cataclysm and also StarCraft II alike and together with our other existing games like the Fantasy Westward Journey also Westward Journey Online II and three Heroes of Tang Dynasty and Tianxia II alike. Based on our current business development for those games that we have already launched out the expansion packs then we will work based on these premises.

But for the other major game titles we do have some plans of launching new expansion packs in the second half of this year. Up to now if you are talking about Diablo 3 I think there is nothing that the companies will be commencing at the moment and with our current cooperation with Blizzard will be on the World of Warcraft and also the StarCraft II.

Very good, thank you for the information, very helpful. I'll turn it over.

Okay, thank you.

Okay.

Thank you, and our next question comes from the line of Adam Krejcik from ROTH Capital Partners, please go ahead.

Yes, hi, thanks for taking my call, congratulations on the quarter. My first question is I'm wondering if you could comment on the expansion pack for Fantasy Westward Journey? Should we expect that in Q3? Then will it be as comprehensive an update as last year? I think it was very well received. Just wondering how big of an expansion pack this is?

(Spoken in Chinese)

Okay with regard to your questions about the upcoming expansion plans for Fantasy Westward Journey. I think basically our perspective is that no matter how big or small it is for the expansion packs the fact is the gaming title itself has been in operation in the market for over eight years with over 10+ expansion packs already in place. As always we do put a very high importance on the user experiences and their expectations and demands from the games.

To have the new game expansion packs that we are going to introduce to the game players themselves we would always introduce some new game play and new game content and features to make sure that the gaming experiences of the players will be well positioned and also give a very satisfying experiences.

We do have a very good confidence that for the upcoming new expansion packs that we are going to roll out in the market this will also follow what we have been doing in the past and also we do anticipate also a well-received response from the market alike.

As for the general staff developed, game developments for the second half of this year, there is another game that we would like to make a note here about a game called the [de bera] land which will be focusing on some perhaps racing and with also some interesting features for the game titles. We do believe that for this new game types to the market this will also have a very new and refreshing feel to the market and the players alike. Thank you.

Great, thank you for that. My second question is on the micro-blog and emails you've been getting a lot of traction. I was wondering do you plan to hire additional personnel R&D or invest heavily in the second half of the year to support those initiatives? Thank you.

(Spoken in Chinese)

Okay with regard to the questions about the Company strategies on the micro-blogging and also the e-mail services. Basically I think the Company will continue to increase our investment in terms of the resources for both the micro-blog and also the e-mail services. We also believe that the e-commerce business in the China market will also get an increasing trend and in order to meet the needs or the expectations of the market we do still continue to strengthen and enhance the existing functionalities and also the capabilities of both our e-mail and also our micro-blogging services.

But in terms of the micro-blogging business services I think currently the major challenge to NetEase would be how we are to position ourselves in the market rather than there would be any questions regarding from the technical point of view. As always NetEase has a very good group of very excellent engineers, to make sure that we do develop and roll out some very good service delivery in terms of the micro-blogging and also the e-mail services. Thank you.

Thank you.

Thank you and our next question comes from the line of Andy Yeung from Oppenheimer. Please go ahead.

Hi good morning, thank you for taking my question. My question is regarding your balance sheet. You obviously have a very strong and significant cash position of $1.7 billion and you know also very strong cash flow, free cash flow for $160 million per quarter. So overall can you give us some insights into you know your plans for the use of cash? Also you know do you have, have you considered any special dividends or share buyback at this time?

Okay thank you for the questions. I think by now we do note that the current economic environment is very challenging and we also appreciate that there are varying options being adopted by our peers in the industry lately to utilize certain of their surplus cash balances. Say for example the issuance of special dividends or something like that. But from the Company's perspective we will continue to look for ways to maximize the yield on our existing cash balances while identifying other investment opportunities.

At the same time we will also consider any potential share buybacks as when we find an appropriate time and good market conditions.

Okay, thanks. Then my next question is a little bit about you know the overall philosophy on online gaming business. Obviously you have one of the more diversified game portfolios in the industry with both in-house developed games and also licensed games. Going forward what's your view on developing games in-house versus licensing games from outside and what's the criteria for either one of them?

(Spoken in Chinese)

With regard to the overall online game development philosophies or the strategies, I think basically there would be two points that we would place focus on. First we would consider the mix of our varying group of players or the users and also secondly how they would like to play different kinds of new products. Given the fact that NetEase has got ample cash funds up to date we will upkeep our open attitudes towards exploring potential opportunities by identifying some very good game studios. And set up some sort of cooperation by way of licensing the games and perhaps do some acquisitions also.

Because as always we would not preclude all good ideas or good opportunities and we would in fact seriously consider whatever comes to us.

Great, thank you.

Thank you and our next question comes from the line of Atul Bagga from ThinkEquity, please go ahead.

Hey guys, thanks for taking my call and congratulations on a great quarter. I have a couple of questions. First on World of Warcraft I know you guys don't disclose the numbers individually for the games, but maybe directionally if you can help us understand. After the launch of Cataclysm, you know how much, what kind of growth you've seen in World of Warcraft? You know maybe if you can compare this versus when the previous operator, the Nine when they launched the Burning Crusade the growth in World of Warcraft. Is it the kind of similar growth you have seen now with the launch of Cataclysm?

(Spoken in Chinese)

Basically we would like to reiterate that we will not disclose any specific metrics about the performance of our existing games like the World of Warcraft. But we would suggest you take a look on how it goes in the upcoming quarters because we are still working on it.

Okay. Can you highlight was the Cataclysm launch in line with your expectations better than your expectations or below your expectations?

I think still what we're seeing is that since the launch of the new expansion packs the Cataclysm for the World of Warcraft the player engagement has been very strong.

Okay. Fair enough. Moving on I have a question on your micro-blogging too. Can you talk a little bit about how do you see the competitive landscape given that a couple of your competition in this service may have much larger scale? How do you see the landscape changing? Did you think longer term there will be room for multiple micro-blogging services? Or do you think it's going to be dominated by one or two services?

(Spoken in Chinese)

Regarding the competitive landscape on the micro-blogging business strategies there are a few points that William would like to bring up and highlight. First of all the mobile internet development is currently in place in the market and we do appreciate that we would use this kind of services to get information, so exchange information, which are the various users essentially very interested in. But certainly up to now the Company does not have a very clear idea on how this product will relate to some direct income flows to the companies.

Thirdly, while the micro-blogging would be a new way of doing some information gathering or information exchange we do see that product wise the differences amongst different peers in the market would be very small. But we do feel that the real challenge is how we are to upkeep the qualities of the information that are going to provide or exchange using this kind of platform.

Fair enough, lastly, a quick question for you. Renaming your Legend of Westward Journey what was the reason behind that?

Sorry, Atul, I can't hear your questions clearly?

My question was what is the reason behind renaming your game Legend of Westward Journey?

(Spoken in Chinese)

Basically the reasons why we have got a plan to change the name of the Legend of Westward Journey to the Warsong of Westward Journey because we have done sort of a market research. We do see that the market feedback is that very positive for changing this to a new name. At the same time by changing titles to a new name we would also minimize the confusion to the players. Because not to relate this game with our other existing Westward Journey related titles but this will be a totally new game title to the market. This is what we would like to project into the market.

Also up to now the feedback from the market is also very, very big and we do look forward to very good developments for this game title alike. Thank you.

Perfect, no thank you guys. Thanks for the answers.

Thank you and I would now like to turn the conference back over to Brandi Piacente for closing comments.

So thanks everyone for joining us today. If you have any further questions, feel free to contact us. Have a great day, thanks.

Ladies and gentlemen, this does conclude our conference for today. If you would like to listen to a replay of today's conference please dial 303 590 3030 or 1-800 406 7325 with an access code of 4460484#.

We thank you for your participation and you may now disconnect.