NetEase Inc (NTES) 2012 Q2 法說會逐字稿

Good evening ladies and gentlemen and thank you for standing by. Welcome to the NetEase Inc second quarter 2012 earnings call. During today's presentation, all parties are in a listen-only mode. Following the presentation the conference will be open for questions. (Operator instructions) This conference is being recorded today 15 August 2012. I'd like to turn the conference over to Brandi Piacente. Please go ahead.

Thank you, operator. Please note 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 U.S. 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 the 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 NetEase's business and financial results is included in certain filings of the company with the Securities and Exchange Commission, including its Annual Report on Form 20-F. 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 built our reputation on introducing innovative products and services that shape China's internet markets. Through this standard of excellence, we can both satisfy user demand and further elevate China's internet content with our benchmark offerings that continue to drive loyalty and appeal within our growing community.

For the second quarter of 2012 our total revenues increased 12.7% year-over-year with online games growing by 10.8% and advertising services increasing by 20.4%. Our self-developed games continued to drive our growth, capturing the attention of new users and increasing play time within our existing community of game enthusiasts. Standout performances in the quarter came from our self-developed titles including Ghost which achieved record revenue in May, Fantasy Westward Journey and Tianxia III.

The long term success of our self-developed games is driven not only by the top quality user experience and innovative game play we offer, but also by the introduction of new features and expansion of game life cycles through the introduction of new content via the launch of expansion packs; as well as the integration of user feedback. This strategy prolongs the enjoyment of our current users and attracts new players to our diverse expansion of games.

The second quarter was filled with activities to stimulate user demand and during the period we launched open beta testing for Ghost and Tianxia III as well as introduce new content for Fantasy Westward Journey. We also launched new expansion packs for Warsong of Westward Journey, Heroes of Tang Dynasty and Westward Journey Online II and we expect that the impact of these expansion packs to be reflected in the coming quarters as the market absorbs these new activities. We expect other activities in the second half of the year for our self-developed games to include the launch of new expansion packs for Fantasy Westward Journey, Tianxia III, Ghost and Westward Journey Online III.

Our research and development team has been diligently working on new additions to our portfolio of games. The first two of these games, Wu Hun, which we have renamed Kung Fu Master and Soul of Warrior which we have renamed Soul of the Fighter are designed to address users' increasing appetites for action games and further diversify our portfolio. In July we launched initial closed beta testing for these two games and while it is still early in the testing process initial feedback has been encouraging. We are currently preparing to commercially launch both games in the second half of the year. In addition our next generation 3D MMORPG Dragon Sword and 3D action real time strategy game Heroes of Three Kingdoms are being develop to the highest standards of quality and we will be performing technical tests this year to obtain user feedback on those games.

In conjunction with the launch of our new games and expansion packs we plan to conduct our usual large scale promotional activities. Our marketing schedule for hosting (inaudible) promotions Fantasy Westward Journey as well as celebrating the tenth anniversary of Journey Online II and conducting promotional campaigns to market our two new games.

Turning to our portal activities global assets has been growing among China's internet users and we are keenly aware of the importance of offering relevant advertising and portal services that appeal to an increasing mobile society as well as traditional internet users. During the second quarter we continued to attract new advertising customers through content innovations, new product development and service integration among mobile platforms. As a result second quarter revenues from our advertising services grew 42.3% quarter-over-quarter, led by the automobile, fast moving consumer goods and financial services that is coming in as the top performing (inaudible).

High profile sporting events have also been a recent focus among our advertising services. In particular Euro Cup 2012 and the London Olympics have presented globally recognized events in which we have been fortunate to partner our services and secure advertising customers. In the second quarter we were please to secure a strategic partnership with China Network Television to broadcast the most recognizable sporting events worldwide. The London Olympic Games was a key event as well as opening and closing ceremonies broadcast on our portal as well as our top-ranking mobile news application.

For our portal and email business we continue to introduce new attractive content with increased mobile assets. In the second quarter the registered number of users for our micro blogging service increased by 48.8% sequentially to 180 million. Mobile services also increased to 495 million registered users as of 30 June 2012. We continue to advance both services by introducing new content and enhancing the user experience to broaden our existing community.

Across our three core businesses, online games, portal and search we believe in differentiating our platforms by providing a premium user experience with a focus on quality, integrity and ingenuity. Each of our products and services display this concept and we look forward to expanding and diversifying our offerings to meet customers' demand for new content with a robust pipeline of games and activities planned for the second half of the year. This concludes William's update.

Now, I will provide a review of our second quarter 2012 financial results. I will primarily focus on the discussions of margins and expense fluctuations along with net profits.

Gross profit for the second quarter of 2012 was RMB1.3 billion or $208 million. This compares to RMB1.3 billion and RMB1.2 billion for the preceding quarter and the second quarter of 2011 respectively. The year-over-year increase in gross profit was primarily attributable to increased revenue contributions from our self-developed games Ghost, Fantasy, Westward Journey and Tianxia III which was partially offset by decline in revenue from Blizzard Entertainment's World of Warcraft.

Gross profit margin for our online game business was 73.3%, compared to 73% and 70.2% for the preceding quarter and the second quarter of 2011 respectively. Gross profit margins for our advertising business was 33% compared to 19.8% and 43.9% for the preceding quarter and the second quarter of 2011 respectively. The quarter-over-quarter increase in gross profit margin was primarily due to an increase in advertising services revenues. The year-over-year decrease in gross profit margin was primarily due to increased headcount-related costs and video content costs incurred in the second quarter of 2012.

Gross loss margin for our E-mail, WVAS and others business was 11.6% compared to 18.0% and 7.8% for the preceding quarter and the second quarter of 2011 respectively. The quarter-over-quarter change was mainly due to improved performance from our e-commerce business in the second quarter of 2012.

Total operating expenses were RMB437.7 million or $68.9 million compared to RMB355.7 million and RMB365.8 million for the preceding quarter and the second quarter of 2011 respectively. The quarter-over-quarter increase in operating expenses was mainly due to increased selling and marketing promotional activities related to the open beta testing launched for Ghost and Tianxia III in the second quarter of 2012 as well as  increased research and development expenses related to product development. The year-over-year increase in operating expenses was primarily due to increased headcount-related costs which was included in general and administrative expenses and research and development expenses.

Net profit for the second quarter of 2012 totaled RMB875.3 million or $137.8 million compared to RMB941.7 million and RMB772.5 million for the preceding quarter and the second quarter of 2011 respectively. During the second quarter of 2012, we reported a net foreign exchange loss of RMB36.0 million or $5.7 million compared to a net foreign exchange gain of RMB17.6 million and a net foreign exchange loss of RMB3.0 million for the preceding quarter and the second quarter of 2011 respectively. The quarter-over-quarter and year-over-year changes in 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 June 30th 2012 as the exchange rate of the Euro against the RMB fluctuated over the period.

We reported basic and diluted earnings per ADS of $1.05 each for the second quarter of 2012. This compares with basic and diluted earnings per ADS of $1.13 each for the preceding quarters and basic and diluted earnings per ADS of $0.93 each for the second quarters of 2011.

We recorded a net income tax charge of RMB149.5 million or $23.5 million for the second quarter of 2012, compared to RMB163.1 million and RMB92.4 million for the preceding quarter and the second quarter of 2011 respectively. The effective tax rate for the second quarter of 2012 was 14.8% compared to 14.9% and 10.9% for the preceding quarter and the second quarter of 2011 respectively. Our various principal subsidiaries renewed their qualifications as High and New Technology Enterprises in 2011, and therefore enjoy a preferential enterprise income tax rate of 15% from 2011 to 2013, subject to annual review by the relevant tax authorities in China.

The year-over-year increase in effective tax rate was mainly due to the expiration of the enterprise income tax exemption period for certain subsidiaries that were qualified as Software Enterprises, which resulted in an increase in their applicable tax rate from 0% to 12.5%.

As of 30 June 2012 our total cash and time deposits balance was RMB13.8 billion or $2.2 billion compared to RMB11.9 billion as of December 31st 2011. Cash flow generated from operating activities was RMB880.9 million or $138.7 million for the second quarter of 2012, compared to RMB1.3 billion and RMB995 million for the preceding quarter and the second 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. Thanks very much for taking my questions. My first question would be about World of Warcraft. Maybe can you talk about the reasons for the rapid decline in the second quarter. Was it because gamers were waiting for the new expansion pack and they decreased spending? Has the revenue stabilized in third quarter as we see so far? Thank you.

(interpreted) So basically with regard to the questions brought up by Timothy just now with regard to the new expansion packs for World of Warcraft we are still in the preparation phase we're in, and today is 16 August and in fact we would hold media events and activities to share new ideas and contents for this new game. We also believe that with the introduction of those new contents and features of the new expansion packs, the potential impact to the market would be quite positive.

Thank you. Could you maybe also quickly talk about the progress of Diablo III? Thank you.

(interpreted) So basically, with regard to the progress of Diablo III basically we are actively working together with the business line in preparing for it and we will give you more updates as it comes to a more appropriate timing.

Thank you very much.

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

Thank you for taking my question. I have two questions. The first question is related to our research and development expenses. As we've seen the expenses growth very flat in your recent quarters, could William comment on the trend and on the strategy related to these expenses at NetEase?

(interpreted) So basically for our R&D spending strategies, basically our will is that we would like to retain and hire the talented peoples for us to cope with the company's ongoing (inaudible) and expansion. We also believe that by doing so we would be able to maintain our competitiveness in the market as compared with our peers.

Thank you, and then my second question is there other competitors are releasing the micro client version of their major games. Does NetEase have any plans to follow this trend and how does William think of another trend in the client games segment, the cloud gaming?

(Spoken in Chinese)

The question is more about your comments on the whole trend of cloud gaming.

(Spoken in Chinese)

All right, let's pause there for a second so we can have the translation.

I think William has just touched on quite a lot of areas regarding questions about the micro client end games and the cloud games as such. Basically I think for the client end games, basically there is not much difference from the way that the current client base game is currently operating. The only exception is that with regard to the download times, maybe there would be a squeeze from two hours to 30 minutes each time for doing so.

But with regard to the core competitiveness of [Orbit] games I think it will still be getting down to the game play and the content that we offer in the market that is more important. With regard to the cloud games features, I think basically there is not much from what we have already doing for now. The only things that may come up would be on the datas that we are going to keep -- the database for facilitating those games, making use of the cloud technologies.

Regarding the trend of the cloud gaming development I think it is still not a question of whether it is cloud or not but whether it is a good game titles that are going to roll out to the market, because in the end we believe that for some good quality games that would be able to roll out to the markets then the people would have better experiences such.

The overall strategies for NetEase in the gaming front is that for whatever categories of games that we are going to launch in the market, we would go for the highest quality and the premium content that we are going to offer in the market. We also try our best to make sure that we would perform in the market with the number one and number two played.

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

Yes, thank you. I wanted to get a little more color on your games marketing schedule in the second half of the year. I know you have a lot of activity around second half expansion pack launches and two new game launches. Will we see more of the marketing effort concentrated in Q3 or in Q4?

(interpreted) Okay, basically Mark, with regard to your questions about our views on how we are going to roll out the new games in the second half of the year. Basically we have got some new games coming up in the second half of 2012, touching on the ARPG genres. But other than the action RPG games that we are going to roll out in the market we would also like to highlight that we should not only focus on the new games that we're going to roll out but can also take the [low] on some of our older games, so those that have been operating in the markets for a few years, like the Fantasy Westward Journey and in past quarters that it has also come with a very encouraging PCU number so 2.17 million people at one time, which is very encouraging. From there we also reinforce our visions that the good quality games with the right content who have actually got a very good response in the market.

Thank you. Our next question comes from the line of Jin Yoon with Nomura. Please go ahead.

This is (inaudible) on the line today for Jin Yoon. Thank you very much for taking my questions. I just have two quick questions. One is if you could elaborate on the margins for your self-developed games, kind of where that's trending and secondly a housekeeping question. Where would you expect your margins to be in the next two quarters?

So basically with regard to our margins for our games, because we would do it comprehensively by taking both the self-developed games and also the licensed games together. So you will see basically from our press release that we also got separate disclosures in the segmented information where the composite margins would be somewhere around 73% and in the third and fourth quarters there has been a mild increase to 73.3%. Actually, if you look back in the early years when we were just operating with just our self-developed games the margins would be much higher but in the near term we still believe that this would be the kind of margins that we would be looking at.

I see. Thank you.

Thank you. Our next question comes from the line of Atul Bagga with Lazard Capital. Please go ahead.

Hi guys, thanks for taking my questions. I have two questions for you. Number one, in second quarter when you look at the sequential decline in online gaming revenue, is it all coming from World or Warcraft or is any of the in house game also showing any weakness? What was your expectation? And the second question is with regard to your RIBO service, your micro blogging service, you saw pretty nice growth in second quarter in terms of the user number. What is driving that, a, and b what's the plan, how do you monitor that user base? Thank you.

(interpreted) So basically after maybe I just get back to you on your second question. First, regarding our growth in the registered users for the micro blogging services, basically NetEase has got wide area of products and services projecting to the users in the markets in general. We believe that those different kinds of services like the e-mail, the games, the news application and also our Youdao dictionary, kind of services would effectively attract the users in the market in such a way also helps to increase our registered users in terms of our micro blog services as well. We always believe that the quality of our products and services as well as the enhanced and user friendly features that we are offering to the users would be well-positioned to attract a very good group of users using our products and services in general.

On the other hand we have also done some very effective marketing event and activities in order to boast the usage of our products and services in general. We also try to do some cross marketing strategies in order to make our overall business to develop in a more well-managed. These were typically responses for your second question.

With regard to your first question about the decline in the gaming revenues in the second quarters of 2012, basically you're quite right, there is a decline which was mainly attributed from the declines in the World of Warcraft performance.

At the same time maybe, I would also like to bring up to the fact that actually, in terms of the seasonalities for the online gaming business, the second quarter would also somehow be a soft quarters, owing to the fact that in the China market there would the (inaudible) whereas the lower age players would spend less time in playing the games. But in general terms, in viewing the performance of our online gaming business for the second quarter I think it's been quite in line with our expectations.

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

Thank you for taking my questions. So basically I had two questions. One is I just wanted to get more color on the corporate e-mail services and second is on the NetEase handset strategies. Thank you.

(interpreted) So basically with regard to Wallace's questions the first one about email, again basically NetEase is very focused on our email business developments and for this year this will be our 15 years in the business so far, and in the past ten years, over the past ten years we have been ranked number one in the free email service market.

We always believed we have an absolute leading position in the free email services, and at the same time as well as the free email services that we are offering in the market we also have another category of services called the VIP Mailbox where we have also enhanced the features to facilitate the usage by our users like the e-fax functions where it would be very user friendly and convenient for the users to get fax and all to send from there.

Although the total user numbers in terms of the VIP Mailbox is not very big for now but we do see that it has got a very good way for further growing in this sense. We always believe that we do have a very good quality and (inaudible) of this kind in terms of the communications kind of products and services offering in general.

With regard to Wallace's second question on the mobile internet kind of stuff, basically I think for now NetEase has got quite a diverse array of applications in place like the Youdao dictionaries where lately installations number has surpassed 100 million already. Also we have our own mobile news apps where it will be very easy and convenient for the people to grab the latest news, especially for the recent Olympic Games and such.

From the strategy point of view I think basically we would be targeting towards three areas, like the information, the utilities or the (inaudible) kinds of stuff and also the education. So there you will see that for NetEase for now we have quite a lot of applications from there, like the NetEase mobile news apps and also the Youdao dictionary, our cloud nooks and our cloud reading and things like that. In terms of the education we have our open education applications as well.

Going forward, we do see that there has been a trend in terms of the developments for the mobile internet and we do see that there would be somehow some changes in the way people are socializing, getting information, doing communication and such and we would put a new emphasis and focus in further development in this area.

Thank you. Our next question comes from William Huang with Barclays. Please go ahead.

Hi, good morning and thank you for taking my call. I have two questions. My first question is about advertising. So what is your outlook for second half advertising environment? Is there any difference NetEase is seeing or experiencing in overall advert outlook versus other peers given that most other company guide a bit softer outlook? Thank you.

So I think basically with regards to the outlook for our advertising business in the second half of this year, we are in active communications with our advertisers and have solid working relationships with these customers. We think the operations would begin with customers in the second quarter solid foundations for the coming period. While we do not provide any guidance in this area we are still cautiously optimistic with respect to our business growth in the second half of the year, which takes into account the seasonality issues and also the impact of the London Olympics.

Okay. I have a follow up question about the gaming business. Can you update the performance, the latest performance of your newly launched games titles such as Heroes of Three Kingdoms? Given the more competitive landscape, how shall we expand the user traffic monetization attention in the next few quarters? Thank you.

(interpreted) Okay, basically with regard to the general performance of our games, the newly launched games in the market, I think for 11 new games that NetEase is going to launch in the market, we would be very serious about that and also do a very detailed analysis to see whether particular game titles would fit in with the market expectations, both in terms of the game content, the game play, the features and things like that. If we got a very positive stance about the basic fundamentals of those games that we are going to roll out in the market, then we would be then taking the next step by rolling the games out to the market.

So far, other than (spoken in Chinese) that you have mentioned just now, which in English is called the Soul of the Fighter, the other games that we also feel like to share with you would be Wu Hun or now the name is the Kung Fu Master, those games, although still in the early stage of their rollout in the market but the feedback from both games has been also very positive and quite in line with the company's expectation. Along this line this will be what we are currently doing for those newly launched games and for the upcoming games that we have shared earlier discourse like the (spoken in Chinese) or Heroes of Three Kingdoms, those will be our other new initiatives that we're going to put through to the market in the upcoming period.

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

Yes, it feels like Warcraft has been a bit of a drag on your overall results for several quarters now and I just wondered if you maybe could give us some perspective, and it is a game that's been in the Chinese market for several years, but we have other games, including some of your own, that have been in the Chinese market for longer and yet have managed to continue to grow. Maybe you could offer some perspective on why you think Warcraft is struggling to retain its user base now compared to some of its other titles? Thank you.

(interpreted) By answering to the questions about the performance of the WoW, first of all I think it would be better for us to share some of our experiences of operating one of our regenerating titles called Fantasy Westward Journey. This game in this game's history has been operating for quite a long time and even that the game has been operating for over eight years it still would be able to get some new users to play this game and also make some new records of revenues as well. As such, our experiences have been so that is that for our group game titles with a very experienced R&T teams who would actually do something to understand the actual needs in the market and then to scope them with an ongoing enhancement in terms of the game content and features and we believe this would lay the very good ground for the game title itself for a good growth.

Coming back to World of Warcraft, this is one of the games that we license from the Blizzard Entertainment and we always feel that Blizzard Entertainment is a great game operator as such. We have confidence in the game titles, especially for the World of Warcraft.

Although there has been some drag in terms of its performance for the past couple or so quarters we still believe that with the upcoming launch of the newest expansion pack, which is the Mists of Pandaria, where there are some new titles, new game content in there, we do look forward whether this will make some new hits to the market in the upcoming periods. As always we believe that for some good content and good quality games this will have a very good potential for the growth in the sales.

So there is another highlight or supplement that William would like to share with all of you with regards to the expansion packs, the Mists of Pandaria that are due to launch soon in the China market. One of the very unique and special features of this new expansion pack is that it has embedded quite a lot of Chinese elements in the expansion packs itself and so from there you would appreciate that the (inaudible) do actually put a very serious emphasis about the user experiences or about the users in the China market. We do look forward that with all these new things coming on to the China market there would be a view new (inaudible) bring to the game titles itself.

Thank you. Due to time restriction our last question comes from the line of Thomas Chong with BOCI. Please go ahead.

Hi, good morning everyone. I have only one question. Can management provide some color on the top five games this quarter? Thanks.

So basically, without giving you any ranking in terms of our games I think our top performing games -- or the major revenue contributing games includes Fantasy Westward Journey, Westward Journey Online II, the Tianxia, Ghost, Heroes of Tang Dynasty and also the World of Warcraft.

Thank you. I'd like to turn it back over to management.

Thank you everyone for joining us today. Please feel free to contact Cassia Curran, Investor Relations Manager for NetEase or the Piacente Group if you have further questions. Have a great day.

Ladies and gentleman, that does conclude the NetEase second quarter 2012 earnings conference call. If you would like to listen to today's replay the phone number is 1800 406 7325 access ID 455 6534. Thanks for your participation, you may now disconnect.