NetEase Inc (NTES) 2012 Q1 法說會逐字稿

Ladies and gentlemen thank you for standing by, welcome to the NetEase Inc. first quarter 2012 earnings conference call. (Operator instructions) This conference is being recorded today, 16 May 2012. I would like to turn the conference over to Ms Brandi Piacente, please go ahead.

Thank you operator. 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 liabilities as established by the US Private Securities Litigation Reform Act. Such statements are not guarantees for future performance and are subject to certain risks and uncertainties, assumptions and other factors. Some of these risks are beyond the Company's control and could cause actual results to differ materially from those mentioned in today's press release and in this discussion.

A general discussion of the risk factors that could affect any business and financial results is 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 ir.netease.com. I will now turn the conference over to Onward Choi, Acting Chief Financial Officer who will read the prepared remarks on behalf of Mr William Ding, Chief Executive Officer of NetEase.

Thank you Brandi. Before I begin, please note that for the purposes of this discussion all percentages are based on renminbi. We have a long history of innovations that has helped to shape China's developing internet market. First with development, we have established a deep understanding of the market's appetite and a commitment to providing our growing community with relevant high quality content and services. In the first quarter, we continued to improve our results, the total sales increasing 30.3% year over year to RMB2 billion or $318.2 million. Led by strong sales from our self-developed games, our total online games revenues include 31.4% to RMB1.8 billion or $289.2 million, compared with the same period last year. This growth was based on increasing revenue contributions from our new games Ghost and Tianxia III as well as several of our flagship games like Fantasy Westward Journey, Westward Journey Online II and Heroes of Tang Dynasty.

Our successful execution of our online game strategy has increased in revenue from our newer games has been the result of our continued improvement of our gamers' user experience which was further demonstrated by Ghost's performance in the first quarter. Since its full scale closed beta testing in September, Ghost has grown rapidly, quickly establishing a stable user base and strong revenue stream. Last month the launch open beta testing for this game to introduce new features such as cross server interaction, arena combat and other new content. The player response has been positive and we are quite pleased with this game's strong performance to date.

Our 3D game, Tianxia III has also grown dramatically, benefiting from this unique and innovative game playing mode, Tianxia III achieved record high revenue in the first quarter. We are working to introduce additional exciting content for this game and we plan to launch open beta testing for Tianxia III in the second quarter.

Fantasy Westward Journey and Westward Journey Online II were also standout performers in the first quarter. We plan to build on this momentum with large scale promotional activities and new expansion packs for this game in the second and third quarters. We have a robust pipeline planned for 2012 and plan to launch a number of expansion packs or new game versions in the second quarter, including Heroes of Tang Dynasty, Westward Journey Online III and Warsong of Westward Journey.

In addition to our expansion packs, we plan to build and diversify our portfolio through the introduction of new self-developed games. Our newest games under development are progressing well and in the second quarter we plan to initiate beta testing for four new games, a 3D ARPG called Soul of Warrior, a 2.5D MMORPG Wu Hun, Heroes of Three Kingdoms a 3D action real-time strategy or DotA game and Dragon Sword, the next generation 3D action MMORPG. These highly anticipated games highlights our innovative content and strong R&D capabilities as we continue to bring leading game technologies to China's internet market.

With respect to our line of games, we are pleased to have renewed our contract with Blizzard Entertainment to continue our existing cooperation on Blizzard Entertainment's World of Warcraft in mainland China. We look forward to releasing Mists of Pandaria, the fourth expansion to World of Warcraft, in mainland China as soon as possible.

Turning to our advertising services and portal activities, despite the seasonally slow quarter, our advertising revenue grew by 13.1% year over year led by automobile, internet services and food and beverage services as the top performing sectors. Quarter over quarter advertising revenues declined 48.5% which reflects the typical industry seasonality. We expect the usual increase in advertising revenue in the second quarter and through the second half for 2012 with an added benefit from our planned activities at the London Olympics. Internet and online video advertisements are growing in popularity and we are well aligned to benefit from this trend by providing users with excellent online video services.

During the first quarter our total traffic grew steadily as we continued to focus on increasing our appeal to users by increasing dynamic content, synthesizing user feedback and providing service integration between different mobile device platforms. To leverage the opportunities at the upcoming London Olympics, we will be working with our content provider partners to offer the most up to date and in depth coverage of this exciting event for our portal and mobile internet users. Our Newswire product will play a key role in our mobile coverage. This application has grown quickly in popularity, capturing terrific user attention and acclaim. In the first quarter it was one of the most highly ranked used applications for iOS and Android platforms.

Our micro-blogging and email services also continued to expand. In the first quarter the number of micro-blogging users grew to 121 million, up 24% from 31 December 2011. Similarly, our email users grew by 6.7% quarter over quarter to 480 million registered email users as of 31 March 2012. Our corporate mobile services have also grown considerably. In the first quarter we were named one of the top corporate mobile service providers in China, after only three years since we first launched this service.

NetEase has built a strong foundation with offerings across our online game business, services and portal operations. We continue to build on these fundamentals by driving innovative content, advanced technology and high quality entertainment services that appeal to users of all ages and interests across China. Our loyal customer base has secured us a leadership position in the Chinese internet market for more than 13 consecutive years and we expect 2012 will be another prosperous year for our Company and our followers.

This concludes William's update. Now I would like to reveal our first quarter 2012 financial results. I will primarily focus on the discussions of marketing and expanse fluctuations, along with net profit.

Gross profit for the first quarter of 2012 was RMB1.3 billion or $211.4 million. This compares to RMB1.5 billion and RMB985 million for the preceding quarter and the first quarter of 2011 respectively. The quarter over quarter decrease in gross profit was primarily attributable to a seasonal decline in advertising revenue. The year over year increase in gross profit was primarily attributable to increased revenues from our self-developed games Ghost, Tianxia III and Fantasy Westward Journey which were partially offset by declines in revenue from Blizzard Entertainment's World of Warcraft.

Gross profit margins for the online gaming business was 73% compared to 72.6% and 70% for the preceding quarter and the first quarter of 2011, respectively. Gross profit margins for the advertising business was 19.8% compared to 54.5% and 33.4% for the preceding quarter and the first quarter of 2011 respectively. This quarter over quarter decrease in gross profit margin was primarily due to a decline in advertising revenues as this billing evolved. The year over year decrease in gross profit margin was primarily due to increased headcount related costs and content purchase costs in the first quarter of 2012.

Gross loss margin for our email, WVAS and others business was 18% compared to gross profit margins of 2.2% and gross loss margins of 21.6% for the preceding quarter and the first quarter of 2011 respectively. The quarter over quarter change was mainly due to increased customer services costs and technology support costs in the first quarter of 2012.

Total operating expenses were RMB355.7 million or $56.5 million, compared to RMB529 million and RMB292 million for the preceding quarter and the first quarter of 2011 respectively. The quarter over quarter decrease in operating expenses was mainly due to the fact that there were less selling and marketing promotional activities in the first quarter of 2012. In addition, an intended provision of RMB50.3 million on initial online game license fee for Blizzard Entertainment's StarCraft II was recorded in the fourth quarter of 2011. The year over year increase in operating expenses was primarily due to increased headcount related costs and increased research and development costs related to product development.

Net profit for the first quarter of 2012 totaled RMB941.7 million or $149.5 million compared to RMB898.6 million and RMB737.4 million for the preceding quarter and the first quarter of 2011 respectively. During the first quarter of 2012 we reported a net foreign exchange gain of RMB17.6 million or $2.8 million compared to a net foreign exchange loss of RMB36.4 million and a net foreign exchange gain of RMB25.3 million for the preceding quarter and the first quarter of 2011 respectively. The quarter over quarter and year over year changes in foreign exchange gains and losses were mainly due to the exchange gains and losses from Euro-denominated bank deposit balances as of 31 March 2012 as the exchange rate of the Euro against the RMB fluctuated over the period.

We reported basic and diluted earnings per ADS of $1.14 each for the first quarter of 2012. This compares with basic and diluted earnings per ADS of $1.09 for the preceding quarters and reported basic and diluted earnings per ADS of $0.90 and $0.89 respectively for the first quarter of 2011. We recorded a net income tax charge of RMB163.1 million or $25.9 million, compared with RMB122.6 million and RMB37.2 million for the preceding quarter and the first quarter of 2011 respectively. The effective tax rate for the first quarter of 2012 was 14.9% compared to 11.8% and 4.8% for the preceding quarter and the first quarter of 2011 respectively.

Our various principal subsidiaries renewed their qualifications as High and New Technology Enterprises in 2011 and we have continued to enjoy the preferential enterprise income tax rate of 15% from 2011 to 2013, subject to any review by the relevant tax authorities in China.

The quarter over quarter increase in effective tax rates was mainly due to the expiration of the enterprise income tax expansion period for certain subsidiaries that would qualify as software enterprises which resulted in an increase in the applicable tax rate from 0% to 12.5%. The year over year increase in effective tax rate was primarily due to the recognition (technical difficulty).

As of 31 March 2012, our total cash and bank deposits balance was RMB13.1 billion or $2.1 billion compared to RMB11.9 billion as of 31 December 2011. Cash flow generated from operating activities was RMB1.3 billion or $212.3 million for the first quarter of 2012 compared to RMB1.2 billion and RMB969.3 million for the preceding quarter and the first quarter of 2011 respectively.

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

Ladies and gentlemen, we will now begin the question and answer session. (Operator instructions) Our first question comes from the line of Timothy Chan with Morgan Stanley. Please go ahead.

Good morning William, Onward and Brandi, congratulations on a pretty strong quarter and thanks for taking my questions. My first question would be, you have a pretty rich in house developed game pipeline, can you please talk about which games you have high expectations on and how are these games different from other games in the market? I have a follow up question, thank you.

(spoken in foreign language).

The highlights of William's comments and remarks on Timothy's first questions regarding the differences of the new launch of the games to the market were basically summarized as follows.

In 2012 basically the various launch of the games to the market was mainly distinguished by the different game genre or different games types that we have launched into the market. For example, there would be some new game pipeline the proper games and some things like ARPG games, such as the Soul of Warrior that we intend to launch.

As for our own capabilities with regard to the MMORPG games, definitely that is very strong in this area and we are already coming to the next generation in terms of our development capabilities. We also believe that in terms of our output, the total levels or the qualities of our output delivery would be further enhanced and increased. So the new themes that we are going to launch for this year, definitely we would have some good expectations to them, but having said that, we would still make a remark that we would like to see until the third quarters of this year when we run the games and see how it performs in the market. Thank you.

Thank you. My second question would be maybe could you talk about your M&A strategy because according to some news reports, you have allocated RMB2 [billion] to your weekly fund. What areas are you looking at and what are the investment criteria? Thank you.

So physically we've captured M&A Strategy, you are quite correct in saying that the Company has set aside about RMB2 billion to work on this area. Basically we would invest in some initially or early stage to the industry with regard to our business, just like internet related business. Of course at the moment we are working on it and we will give you more color as we get into more details.

Thank you, that's very helpful.

Thank you and our next question comes from the line of Alicia Yap with Barclays, please go ahead.

Good morning William, Onward and Brandi, thanks for taking the questions. Very quickly, number one is that I wanted to get some color on how should we think about the sales and marketing expense in the second quarter and going forward, given that you're going to be releasing a number of the new games and expansion packs in the coming months.

(spoken in foreign language)

So basically William has commented that for the upcoming quarters expecting on the determined marketing. Of course there would be an increase because traditionally the first quarter would be the low season and given the fact that that would be the Chinese New Year as well, so usually we would be deploying less resources or money during the promotion and activities and things like that. Given the fact that in upcoming quarters we would have some new games and new (technical difficulty) launched to the market and then we would upkeep a reasonable percentage of our sales and marketing expense spending in this area.

I see. Second question is that can you comment on the general advertising demand environment in the second quarter, if you have any visibility into the second half. Then with that, have you started to receive or seen some Olympics-related spending so far?

(interpreted) So basically this year the launch of the Olympics after a four year period and physically we already get set and prepare ourselves to reap the benefits of the London Olympics for this year. Up to now, we also anticipated that there would be some new demand, especially the advertising demand with regard to the London Olympics for this year. The overall outlook for this year is still for a positive result for the general advertising business.

Great, thank you, congratulations on a solid quarter.

Thank you and our next question comes from the line of Dick Wei with JP Morgan, please go ahead.

Hi, thank you for taking my questions, I have two questions. First question is on the web games side. I wonder many of the MMORPG companies, they are trying to get into the web game market, I wonder what William thought on the potential success for these companies and what about the plans for NetEase and how that is different from this Company in terms of web game development.

(interpreted) So basically we also place some importance on the new change of the trend in the gaming markets from the MMO toward the web games area because this would be a new game mode in the overall market. Of course for NetEase, we do have a few game titles trying out in this area and we are keen to look out how this will be going. Basically for the web games and the MMORPG games, basically those two types of things are quite similar, except for the fact that for the MMORPG games, the players will need to download the client base before they will be able to play the games. Overall sense we would upkeep a relatively calm attitude towards its development for the time being.

Great, thank you. My second question is on mobile monetization.

(interpreted) So with regard to the mobile monetizations, at the moment we do not have any specific plan yet, but we do -- are aware that this platform is a very good way for us to launch various kinds of [Yeso 2s] or to facilitate the users to make good use of the incremented times. Up to now, for many we have our news applications, reading applications, the [Knox] style from the Youdao and also the Dictionary and stuff like that. We do believe that this would be a very good way for us to have good offerings of new applications on these platforms to facilitate the users' experience in this area.

Thank you.

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

Hi, thank you for taking my questions. Congratulations on a very good quarter. I have three quick questions. Number one is, we understand that the Diablo III launch date and contract's not that clear, but given what we have seen, the strong performance in US and also in Korea, how would management think then is Diablo III going to be launched in China? Would there be any potential impact on the rest of the games of NetEase?

Second question would be on the R&D expenses. It seems like it's still gone up quite recently in particular in the share base compensation expenses, I think last quarter it's actually gone up a lot. Is NetEase hiring more engineers and also are you paying more --higher salaries due to attracting talent?

Final question will be, I think I've asked this question many, many times, but unfortunately there are a lot of maybes that report recently again on NetEase's potential shipment of handsets. I don't know what is the reason behind this, just wanted to get a very quick final comment.

(spoken in foreign language)

So, basically with regards to Wallace's three questions, maybe I'll recap the highlights from William's remarks one by one. With regard to Wallace's first question on D3, its potential impact to China and especially to NetEase, I think what NetEase is doing is we are still in progress of preparing for Diablo III. And we, for whatever new launch of the games dealer market, do emphasize the importance of the users' businesses. And we would try to make sure that the users' businesses would be secure before the launch of this game in the market.

On the second question, regarding the increase in the R&D expenses, or the related SBC expenses, I think this would just be a reflection from how we focus on the human capital within NetEase and how willing NetEase would be to invest on the human capital in order to make sure that we are a very competitive company. On the other hand, the increase in the R&D expenses would be another reflection on our competence and we would like to make sure that the long-term developments of the Company would be secure. At the same time, given the very competitive environment or the landscape in today's Chinese market, we also believe that it would be a good thing for us to (technical difficulty) of the good results with our staff in general.

And for the third question regarding the potential shipments or the launch of our phone handsets, this is one of the topics that we are currently seriously considering.

Thanks for the very much for the great answers. Just two quick follow-ups. One is regarding Diablo III -- do we see the quite significant overlap between the Diablo III and World of Warcraft users? Will the launch have any kind of potential cannibalization? The second point will be on the R&D expenses -- so, can we have an update on the total number of headcounts, especially (inaudible) of the first quarter? Thank you.

(spoken in foreign language)

Basically -- Wallace, with regards to your first follow-up question regarding Diablo III, basically, we do not comment or do any projections on how it would be viewing upon the launch of this game to the markets. And for your second follow-up question regarding the R&D headcounts, up to the end of the first quarter 2012, it would be somewhere around 1700 people.

Thank you. (spoken in foreign language)

Thank you, and our next question is from the line of Jialong Shi with CLSA. Please go ahead.

Hi. Good morning William and Onward and congratulations on a very solid quarter. I have a few questions. You mentioned on your earnings release that you have a few new games ready for beta testing across the following quarters. So, could you provide a little bit more details like the respective quarters you expect to roll out these new games? Also, if I remember correctly, Soul of Warrior already started closed beta testing in April, so how is the performance of this game during the testing? I have a follow-up question.

(interpreted) Basically, in regards to Jialong's first question, for the launch of our new games for this year, basically we would have a schedule geared towards the second (inaudible) for this year, and we will give more color as we come closer, and perhaps give more announcements on our official websites. With regards to the comparison on the closed beta testing of the Soul of Warrior, which is -- some other games like Ghost, because those two games are quite different in nature, one would be an ARPG and the other would be MMORPG game. So, basically, they are not very comparable in this sense. Also, we feel we want to take some more time to see how those new games would be performing after the closed beta testing.

Thank you. My next question is about Dragon Sword. Could you provide some color on the unique features of this game compared to those existing games in the market?

(interpreted) So, basically, our development teams on the Dragon Sword has got a very strong 3D plan experience on this type of game and we also anticipated that through their hard efforts in developing this new game, they will be able to bring some new experiences to the gamers in general in the China market.

Thank you. I've asked my last question on your e-mail surveys. You mentioned on the earnings release that you now had 480 million e-mail subscribers. So just wondering if you could provide any data points like the daily or monthly active users for all e-mail services and also how many users for your corporate e-mail service?

(interpreted) So, on a monthly basis, basically, our active users who would be logging into our e-mail services would be over 100 million and for the corporate e-mail users would be over 40,000.

Thank you. Our next question comes from the line of Martin Bao with CICC. Please go ahead.

Thank you for taking my question. This is regarding the Fantasy Westward Journey and Westward Journey II. It would seem that you have introduced innovations and new feature things from newer games like the Ghost and Tianxia III, and I would like to know the updates and update plans -- do we have any plans to introduce those new features in those two older games in our portfolio?

(interpreted) Basically, we are always striving to make many new innovations to our existing gameplay to various game products and through some new innovations or the creation of some new game features, of course, we will try to share something that is really well received or popular amongst different games. This is always our philosophy of running our gaming business.

Thank you. (Spoken in foreign language)

Thank you. Our next question comes from the line of Mark Marostica with Piper Jaffray. Please go ahead.

Yes. Nice job on the quarter and thanks for taking my question. My first question is with regards to the new expansion pack for World of Warcraft -- Mists of Pandaria -- and I'd like to get your thoughts as to how different this expansion pack is for the franchise and whether or not William thinks it will rejuvenate the game going forward? And then I have a follow-up question.

(interpreted) So, basically, Mark, your question regarding the new expansion pack, I think at the moment what we can share with you is that they're well underway, and there is not much we can share for now. But let's stay tuned with our official announcements and perhaps if you take a look at our official website from time to time, we will give you more information when it comes to a more suitable time.

Then a second question regarding the advertising business. You talked about investing in content purchases and headcount related costs in the first quarter and I'm curious whether or not we should expect to see the second quarter bear the same level of activity on the content purchase front and headcount side or if the bulk of that was taken care of in the first quarter? I'm just trying to drive at the behavior of advertising gross margins in the second quarter and going forward. Thank you.

Mark, with regard to your second question on the advertising business, on the content procurement costs or the headcount related costs. Of course, for this year, especially in the first quarter, there has been some pressure to this because you will also foresee that we have also introduced some new contents, such as the online video contents, which the costs will be a bit higher.

But if you take a look at the fact that usually the first quarter will be the low season for the whole year, we do see that going forward to the second quarter and the rest of this year, the situation will be progressively improved. And we do see that there would be some enhancement in terms of the gross margins for the advertising business in the upcoming quarters.

Thank you. Just one housekeeping item on the tax rate -- you talked about the tax holiday expiring in Q4 for some subsidiaries, how should we model taxes going forward given the situation you described? Thank you.

So, basically, on an annualized basis, I would suggest you take about 15% as the tax rate for the whole year.

Thank you.

Thank you. Our next question comes from the line of Doug Creutz from Cowen and Company.

Yes. Thank you. Conceptually, I think we've seen in the United States that there has been somewhat of a shift from PC gaming onto mobile devices, and I was wondering what you think of that potential turn in China? How you think you'd want to address that? Do you think it's a threat to your business or an opportunity and just generally how you're thinking about that?

(interpreted) So, basically, with regard to Doug's questions on the overall change in the internet market from the PC platforms to the mobile platforms, we believe that this is a positive thing to happen. In fact, such change, it's possible, cannot be escaped and cannot be avoided. We also looked at -- currently, the mobile handset market has been very competitive given the fact that the costs of the mobile handsets is going down every now and then and that the mobile handsets, say, for example, the smart phone, is getting its popularity more and more in the China market. So, this is definitely a new trend that we have seen and taken note of.

So far for NetEase, we do have quite have a lot of very popular and useful applications in this area to facilitate users to use such functions on their mobile handsets, such as the Youdao Dictionary, the Youdao Note and many others. In fact, this morning, William has always read news that is very encouraging because the Apple apps have also ranked our Youdao Dictionary as their editor's choice of application, which is a very good thing to know about.

Going forward we do want to make another step forward by putting our cloud service -- to make use of the cloud technologies to roll forward our mobile applications to the various users using the mobile handsets and things like that. On the other note, with regards to the online gaming developments, or the change in the trend from the PC to the mobile platforms, I think this is the very important topics that we are currently seriously thinking about and considering.

Okay. Thank you. That was a very thoughtful answer, thank you.

We have no further questions. Management you may continue.

Thank you once again for joining us today. Please feel free to contact NetEase's investor relations manager, Cassia Curran, or the Company's IR firm if you have further questions. Have a great day. Thank you.

Ladies and gentlemen that does conclude the NetEase, Inc. first quarter 2012 earnings conference call. If you'd like to listen to today's replay, the phone number is 1-800-406-7325. Access ID -- 4533318. Thank you and have a good day.