NetEase Inc (NTES) 2012 Q3 法說會逐字稿

Ladies and gentlemen thank you for standing by and welcome to the NetEase Incorporated third quarter 2012 earnings conference call. During today's presentation all parties will be in a listen only mode. Following the presentation the conference will be open for questions. (Operator instructions) The conference is being recorded today. I would now 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 US Private Securities Litigation Reform Act. Such statements are not guaranteed to 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 its 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 SEC -- Securities and Exchange Commission including its annual report on Form 20S. 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 Mr. 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. For the first quarter of 2012 we reported total revenues of RMB2 billion driven by our online games and increasing advertising revenue contributions. During the third quarter we continue to advance our growth strategies for our self-developed games by introducing expansion packs that extend the lifecycles of our games attract new users and by launching new games that broaden and diversify our portfolio. As we continue to focus on improving game content and quality, the popularity of our self-developed games is escalating. Coupled with our successful promotional activities to better serve our players NetEase branded games are contributing in increasing amount to our online game revenues mix.

Total online game revenues for the third quarter were RMB1.7 billion driven by increasing revenue contributions from our self-developed games. We have standout performances from Fantasy Westward Journey, Westward Journey Online II and our two new games, Kung Fu Master and Soul of the Fighter. (Inaudible) also achieved steady performance during the third quarter.

Following the release of expansion packs and new content in the second quarter as well as associated promotional activities, both Fantasy Westward Journey and Westward Journey Online II achieved record high PCUs in August. In the third quarter we introduced new expansion packs for Fantasy Westward Journey, Westward Journey Online III and Tianxia III including 3DX versions for Tianxia III that offers even more exciting 3D effects.

We are also very pleased with the performance of both our two new action games the high quality fighting experience provided by Kung Fu Master and Soul of the Fighter has been well received by players. We follow this positive resurgence and user feedback by launching unlimited beta testing for games on September 13th and October 18th respectively which were met with equal enthusiasm.

The October 2nd release of the highly anticipated fourth expansion pack of Blizzard Entertainment's World of Warcraft -- Mists of Pandaria in mainland was another important milestone during this period with elements that appealed to China's culture, Mists of Pandaria has proven to be especially engaging and we believe that it has been widely embraced by China's gaming community.

As we look to the final quarter of 2012 and move into 2013, we will continue to focus on providing premium quality and addressing user demands through our best [in-class beta] channels. We are pleased to announce that we will launch Heros of Tang Dynasty II on November 16th. This will be a comprehensive upgrade of our popular and long running game Heros of Tang Dynasty to further build on the success of this game. Our plans for the coming months also include introducing two new games to broaden our portfolio and game styles. Heros of Three Kingdoms, our 3D action real-time strategy game and Dragon Sword our next generation 3D MMORPG.

Turning to our portal business we continue to enhance our portal content which helps to strengthen our community and drive our advertising services revenues through the loyalty of our current advertisers and by attracting new advertisers to our leading portal. Advertising sales continue to improve in the third quarter with automobile, fast moving consumer groups and financial services as the top performing (inaudible). In the third quarter our advertising sales grew 10.2% year-over-year and 19% sequentially. Our advertising business benefited from the popularity of our leading mobile news applications as well as our broadcast of the London Olympics. Our London Olympics coverage was extremely successful this year resulting in an unprecedented number of downloads and portal activity that exceeded our results from the Beijing Olympics in 2008.

Our email services are also continuing to gain momentum and as of September 30th, 2012 we have approximately 510 million registered email users. Ongoing integrations of mobile internet use services remains one of our top initiatives. We now have more than 60 million registered mobile email users and 27 million installations for our mobile news applications. We continue to build on this community with enhancements that meet the needs of our users.

China's internet community is thriving and we are dedicated to furthering our leadership position in this expansive opportunity where we have developed some of the most long lasting and popular online games in China. Our large community of loyal users continues to grow and we are working to achieve healthy growth across our business segments while advancing our leadership and maintaining our competitive advantage.

Lastly, we greatly value our users and community as well as our shareholders. Shareholder value has always been of great importance to us. Our business has been strong with increasing revenues and robust operating cash flow. As such, we believe now is an opportune time to return value to our shareholders. We are happy to announce that our Board of Directors has approved a special cash dividend of $1.00 per ADS along with a $100 million share repurchase program to enhance the return we provide to our shareholders as we work to further grow the Company. This concludes William's update.

Now I will provide a review of our third quarter 2012 financial results. I will primarily focus on the discussions of margins and expense fluctuations along with net profit. Gross profit for the third quarter of 2012 was RMB1.4 billion or $216.7 million. This compares to RMB1.3 billion for both the preceding quarter and the third quarter of 2011. The quarter-over-quarter increase in gross profit was primarily attributable to increased revenues from advertising services primarily attributable to seasonality and our broadcast of the London Olympics and increased revenues from our self-developed online games, primarily Fantasy Westward Journey, Westward Journey Online II and our two new games Kung Fu Master and Soul of the Fighter.

The increase was partially offset by increased content costs related to the Olympics and by increased revenue from Blizzard Entertainment's World of Warcraft. The year-over-year increase in gross profit was primarily attributable to increased revenue contributions from our self-developed games Fantasy Westward Journey, Ghost, Tianxia III, Westward Journey Online II and Kung Fu Master as well as Soul of the Fighter. The increase was partially offset by decline in revenue from Blizzard Entertainment's World of Warcraft and increased advertising costs including headcount related costs and content costs.

Gross profit margin for our online game business was 74.2% compared to 73.3% and 71.5% for the preceding quarter and the third quarter of 2011 respectively. The improvement in gross profit margin was primarily due to the increased revenue contributions from our self-developed games as a percentage of our total online game revenues. Gross profit margins for our advertising business was 36.2% compared to 33% and 48.4% for the preceding quarter and the third quarter of 2011 respectively. The quarter-over-quarter increase in gross profit margins was primarily due to economies of scale as advertising revenue increased in the third quarter of 2012. The year-over-year decrease in gross profit margins was primarily due to increased headcount related costs and content costs incurred for the London Olympics.

Gross profit margin for our email, WVAS and others business was 6% compared to gross loss margins of 11.6% and 13.2% for the preceding quarter and the third quarter of 2011 respectively. The improvement in gross margin was mainly due to increased sales of our game related accessories such as limited edition packages of several online games.

Total operating expenses were RMB537.5 million or $85.5 million compared to RMB437.7 million and RMB408.2 million for the preceding quarter and the third quarter of 2011 respectively. The quarter-over-quarter and year-over-year increases in operating expenses were mainly due to increased selling and marketing expenses. Major marketing and promotional activities including the summer vacations promotions of Fantasy Westward Journey, the 10th anniversary ceremony of Westward Journey Online II, unlimited beta testing for Soul of the Fighter and promotions for Blizzard Entertainment's World of Warcraft -- Mists of Pandaria as well as higher staff related costs due to increased headcount and increased investments in our product development pipeline.

Net profit for the third quarter of 2012 totaled RMB811.9 million or $129.2 million compared to RMB875.3 million and RMB825.8 million for the preceding quarter and the third quarter of 2011 respectively.

During the third quarter of 2012 we reported a net foreign exchange gain of RMB23.7 million or $3.8 million compared to net foreign exchange losses of RMB36 million and RMB65 million for the preceding quarter and the third 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 September 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 $0.98 each for the third quarter of 2012. This compares with basic and diluted earnings per ADS of $1.06 each for the preceding quarter and basic and diluted earnings per ADS of $1.01 and $1.00 respectively for the third quarter of 2011. Basic and diluted earnings per ADS for the third quarter of 2012 reflect the accrued withholding tax associated with the [offshore remnants] of cash from China in anticipation of the declaration of the special cash dividend.

We recorded a net income tax charge of RMB194.8 million or $31 million for the third quarter of 2012 compared to RMB149.5 million and RMB140.5 million for the preceding quarter and the third quarter of 2011 respectively. The effective tax rate for the third quarter of 2012 was 19.9% compared to 14.8% and 14.7% for the preceding quarter and the third quarter of 2011 respectively. The increase in net income tax charge was due to the occurrence of an accrued withholding tax of RMB40 million associated with the offshore remittance of cash from China in anticipation of the declaration of our special cash dividends.

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

As of September 30th, 2012 our total cash and time deposits balance was RMB14.9 billion or $2.4 billion compared to RMB11.9 billion as of December 31st, 2011. Cash flow generated from operating activities was RMB670.1 million or $106.6 million for the third quarter of 2012 compared to RMB880.9 million and RMB864.9 million for the preceding quarter and the third quarter of 2011 respectively.

Finally, on November 13th, 2012 our board authorized a share repurchase program of up to $100 million for a period not to exceed 12 months as well as a special cash dividend of $0.04 per ordinary share which is equivalent to $1.00 per ADS. Each ADS represents 25 ordinary shares. The special cash dividend is payable to shareholders of record as of January 15, 2013. The special dividend is expected to be paid on January 18th, 2013 with the total amount of cash distributed expected to be approximately $131 million.

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 Richard Gee from Morgan Stanley. Please go ahead.

Hi. William and Onward good morning. Thanks for taking my call. I have two questions. First of all can you help us to shed some color on the flattish year-on-year online game revenue growth and was it largely due to the weakness in World of Warcraft? Also after the reasonably successful launch of Mists of Pandaria, Soul of the Fighter and Kung Fu Master, should expect online game sales to re-accelerate?

(Interpreted) With regards to your first question regarding the performance of online games' flattish trend in the third quarter, I think basically this is actually attributed to the decrease in the revenue contributions from World of Warcraft. Given the fact that the fourth expansion pack for World of Warcraft, which is the Mists of Pandaria, that has been launched on 2 October, we have seen that there has been an upward trend, both in terms of the use and also the performance of the game itself, as such.

Then specifically, because the launch date for this game falls in the fourth quarter, so this would not bring any positive impact in the third quarter. Although there has been a downward trend in the revenue contributions from the World of Warcraft in the third quarter, we believe that going forward that this will be a positive initiative to us.

On the other hand, with regard to our self-developed games, we do see that the game itself is still having a growing trend and we do experience a double-digit growth as well for our own games. For Soul of the Fighter and Kung Fu Master, those games have been launched on 13 September and 18 October respectively. The initial feedback from the games has also been very positive, and this will also be reflective of the fact that NetEase has very strong self-development capabilities and the fact that we always focus and emphasize on the importance of the user experiences, to ensure us to excel and be successful in this business. Thank you.

Thank you. My second question is regarding your mobile internet initiative. Can you give us some color on what's your future plan to further ramp up your mobile internet user base? Also we are particularly interested in your mobile game development plan.

(Interpreted) With regards to our own views on the mobile internet, first of all, William also looked at that. There has been a very strong development in terms of smart phone markets, and there is (inaudible) regarding the Google Nexus phone, which is currently sold at a very confident price of RMB1888, which is very competitive in the current market. We also paid due attentions on the trend in this area.

On the other hand, NetEase also had a very strong and successful launch of the mobile applications on those smart phones, and there are quite a lot of different categories that we are currently offering. Other than the mobile news applications, we also got some Youdao Dictionary, Youdao Note and also (indistinct) and Weibo and things like that. In fact, there are many, many areas that we are currently working on as well in order to fill up our mobile offerings.

One point that we can rest assured is that we would further invest in this area in order to tap into the development of this new trend, and we would also make good news of the experiences that we have accumulated so far, in order to enhance our users' experiences in this sense.

Moving on to the mobile games area, currently the Company has also got some ideas and working on how to better enhance the user experiences of playing those games on the mobile platforms. We are also finding ways to better transmit the best of this kind of experiences using the PC platforms to the mobile platform as well.

At the same time, we will also be finding ways and thinking on how we could better make good use of the fragmented times of the mobile users in this sense. Going forward to next year, hopefully in the first or second quarters of 2013, we will also launch some new initiatives in this area to the market. Thank you.

That's very helpful, thank you.

Thank you. (Operator Instructions) Our next question comes from the line of Dick Wei from JP Morgan. Please go ahead.

My question is on advertising. Can you discuss how much of your advertising revenue is coming from video and what is the trend currently for video advertising? Thank you.

With regard to the advertising revenues, I think for now we do not have a further breakdown on how much it would be coming out from our video, but what I can share with you is that our major revenue contribution will still be coming up from our (inaudible)

I wonder if you can comment on the gross number that you (inaudible) and maybe some of the (inaudible) if you can share. Thank you.

So your question is asking about our outlook of the advertising business, isn't it?

Particularly online video, yes.

(Interpreted) With regard to our view about the photo video developments, first of all, we appreciate that the video content business is very - in terms of the competition, it is very fierce and also intense, and at the same time, the investment is also very costly. For NetEase, we do believe that we do offer quite a lot of quite unique content of features, just like what we have been doing on our mobile platforms and where we have been deploying new resources to roll out the applications that can meet the expectations of the users alike.

In terms of the video content development, I think for now, NetEase has got its own open educations applications on the mobile platforms, and we have already translated over 1000 courses from renowned universities globally. Going forward, I think our strategy is to find out some differentiated strategies from our peers and try to work out something very unique for ourselves to put out to the market.

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

Hi, good morning. Thanks for taking my questions. My first question is also related to your advertising business. I wanted to follow up - can you comment if you have seen any impact from the Japan [auto OEMs] and whether that will impact your fourth quarter revenues, and if you can also share the view on the latest advertiser sentiment on the overall ad budget?

(Interpreted) So with regard to the potential impact of the auto OEM from the Japanese manufacturers, of course, this will not be a stand-alone impact to just NetEase alone, but this applies to the whole industry and impacting the whole media businesses.

There is also something that I would supplement on William's behalf, because we do see that those would be an impact to us in terms of the automobiles contributions. So there would also be something that we need to pay attentions to, especially in the fourth quarter in terms of the revenue contributions. Although we still hold a cautiously optimistic view about the general outlook of the advertisements business, but I think given the effect of the Japanese practice and also the fact that the overall economy is not very warm for now, and so we would see that perhaps there would be a more stable performance going forward.

I see. Very helpful. Second question is on your newly-launched games (inaudible). I wanted to get your view on how are the games performing so far, and among the two games, which games that you think will deliver a higher expectation. Thank you.

(Interpreted) Basically, with regard to the initial performance or the success on the markets since the launch of our two new games, namely The Soul of the Fighters and the Kung-Fu Master, I think we are very happy to say that the positions of rolling out this kind of game channels has been very successful, and we do also take into the interest of the market of people who are looking for some fast-paced action games in this respect.

At the same time, we would also make good use of our existing current capabilities and resources to further enhance or to add in some new end features to those games, and in particular, with regard to our launch of the Kung-Fu Master, although the launch time is not very long because it has just been launched on 18 October and for now today is just 15 November, but so far its performance was also over our original expectations, which is very encouraging.

At the same time, we will make good use of our experiences that have been accumulated for so many years for now to make sure that we will be able to launch out some more new games and bigger games and even more diverse game genres to meet the market expectations. Thank you.

Okay, thank you.

Thank you, and our next question comes from the line of Eddie Leung from Merrill Lynch. Please go ahead.

Good morning, thank you for taking my questions. I have two questions about the [cost] side. The first one is about taxes. Could you give us some color on the fourth quarter tax rate? Because I know you just got it renewed at the high tax status, so is there going to be any one-time tax incentive or tax rebate in the fourth quarter?

Then secondly, could you also give us some color on the operating expenses trending into the fourth quarter? Usually I know that there could be graduates from colleges joining the Company, so would that affect the fourth quarter expenses? Thank you.

Eddie, this is Onward. Would you mind to repeat your first questions, because I can't hear--

Just wondering whether there is any one-time tax incentive or tax rebate in the fourth quarter after the renewal of high-tax status?

Okay, for the first question I think for now we do not think there would be any special tax rebate coming in the fourth quarter, but what I have to clarify with you is that the high [and new technology] enterprises tax status has been granted in 2011, which means that the companies were able to enjoy the 15% preferential tax in paying our income tax in this respect. So I think basically taking out all the other special events that will be happening around, we do see that the tax rate for the companies would be somewhere around the 15% range. This would be our feedback on the first question.

With regard to your second question on the operating expenses, I think you're quite right in saying that the companies would be doing its annual universities graduates intake in the third quarter, and I think those impact has already been somehow reflected in the third quarter financials. Going forward, I think we would see that the cost [level] would be somewhere around what we have been experiencing in the third quarter.

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

Yes, thank you for taking my question. I appreciate the earlier color on the performance of Mists, which seems to be improving in the quarter, current quarter. My question is in relation to the performance of Mists and receptivity of Mists by gamers compared to prior World of Warcraft expansion packs, namely Cataclysm. I wonder if you can give us a sense at the same point in time we are today compared to when Mists was launched, how Mists is performing relative to Cataclysm at that same point in time. Thank you.

(Interpreted) Basically, I think in terms of the performance of the Mists of Pandaria that was launched on 2 October, so far we are having quite a satisfactory comments on feedback, and I think the major differences between the launch of Mists of Pandaria versus the Cataclysms is that in this new expansion packs, we have added in much more Oriental elements where not only the existing players, but also a quite a lot of new players would also find them very appealing, and would like to play and experience these games.

Going forward, we would look forward that there would be some enhancement versions, say for example 5.1, 5.2 versions, for the Mists of Pandaria, where we would pay more attentions on the needs especially of the China market and also to make sure that their demands have been duly addressed.

Thank you, and our next question comes from the line of Tian Hou from TH Capital. Please go ahead.

My question is regarding what could be your pipelines in 2013, and also regarding the web games, what's your thought in that front, how NetEase is going to position itself in the web games sector.

(Interpreted) First of all, with regard to the pipelines in 2013, I think hopefully the [Dragon Sword] which is our next generation 3D MMORPG would be coming out properly in the first half of 2013. At the moment we've also got some -- a few new games under development, which is in the process of having some special codes at the moment.

We feel that all of our pipelines are in very stable conditions and we do see that, given we have accumulated a very good experiences of doing the development of online games, we would continue our efforts to make sure that we can roll out our new game titles and at can get a better experience, both to our users and enhance their experiences and at the same time we would also try and find ways to further enhance our marketing and promotional activities in order to make our game more successful in this area.

Now, with regard to our other developments, including the web games type of stuff, we would take a more conservative and a more cautious approach in dealing with that.

Thank you and your next question comes from the line of Jialong Shi from CLSA. Please go ahead.

Hi, good morning, William and Onward. Thank you for taking my call. I have a couple of questions. The first question is about your game pipeline. We know NetEase has a very big -- as you mentioned, NetEase has a very big game pipeline. Could you give some color on the performance of (inaudible) new expansion pack and also Dragon Sword during your previous task team?

(interpreted) First of all, with regard to the Heroes of Tang Dynasty II expansion pack, first of all, the development of this or the comprehensive upgrade for this game title would be based on our experiences on operating the Heroes of Tang Dynasty before. In these new versions of the game, we would also try to enhance the pace or the user experience as such in order to bring a better experience to our players. These new versions of the game will be open for testing tomorrow. We are very confident of this game and believe this would also bring in another good impact on both the user experience and performance.

With regard to the Dragon Sword pipeline, for the accompanying -- the game itself is in the testing phase and we have also enhanced the experiences and the gameplay within the game, like the fighting kinds of experience. Although we have a very successful experience of operating Tianxia III in the market, but we would also make good points by learning from operating those successful games in order to give new initiatives to the market by rolling out the Dragon Sword in the upcoming future

Thank you. Our next question comes from the line of Thomas Chong from BOCI. Please go ahead.

Hi William and Onward, good morning. I have a question regarding the R&D accounts. Can management give us a sense of how many R&D people in third quarter and how many do you expect to reach by the end of next year? Which area will they be focusing on? You said on client-based games, web games, or mobile games or other areas? Thank you.

(interpreted) So, with regard to William's will on the various game developments, including the client-based games, the web games or local games. First of all I think NetEase will take initiative to analyze markets and also understand what the peers are currently doing, their initiatives, the performance and things like that, in order to identify what we'll be doing in the future. But having said that, we always believe that the client-based game is a long-lasting stream to us and we always believe that there is still room for us to further make our existing client-based game to a much higher quality and to build a much better user experience, alike.

We do see that there would be good opportunities to make good use of our existing client-based experiences, to try out in the mobile games area. But I think that there's no need for us to distract our attentions too much on areas like web games. But I think at the same time we would always take a very proactive approach in observing what the market is currently doing and aware what our peers are currently doing and when there will be something that we would consider worth to do in this respect.

In regards to the mobile games initiative, I think it would be better for us to think of some new ways of doing so and also offer something that would be having its unique features to take into the demands of the market. Thank you. This would be one of the questions that Thomas has raised. The other questions would be regarding the R&D headcount of our Company in the first quarter and our expectations, that would be looking forward going into the fourth quarter.

For the internal developer's number in the first quarter, we have around 2000 for now. As we do not set up any specific targets on how many people that we're going to (inaudible) for a particular moment, but most of the time the increase or the changes in our headcount would very much depend on how our business is going and we would try to make sure that we would recruit and hire sufficient numbers of R&D people in order to meet with the Company's business development plans, as such.

Thank you. Our last question comes from the line of Alex Yao at Deutsche Bank. Please go ahead.

Hi, good morning every one and thank you very much for taking my question. My first question is on the usage side. So from financial perspective the gaming revenue was largely flat Q over Q, or year over year, but from the usage side, are we seeing the active gamer base increase or decrease from Q over Q, or year over year basis?

With regards to our gaming revenues and performance, I think in the third quarter, basically the overall resources has been flattish; and basically from what we have highlighted before, our self-developing has also experienced a very good drop in the third quarters, even if the (inaudible) increased, so you will see that in this trend the numbers of the users has been progressing quite well, especially in the third quarters. You are also aware that in the third quarters for our Fantasy Westward Journey and Westward Journey Online II, both two games have also got some new hit records of [P2] numbers of 2.7 million and 1.27 million respectively for those two games, which is quite encouraging.

By taking the performance of the third quarter into account, I think the decrease of the packaged result would mainly be brought about by the decline in the revenue contributions from the World of Warcraft, as we have also mentioned earlier, because the fourth expansion pack has just been launched on 2nd of October, so there wouldn't be any revenue contribution as such, or incremental revenue contributions that brought about the satisfactory performance in the (inaudible) area.

If you have any closing comments at this time?

Yes, thank you everyone for joining us today. Please note that Cassia Curran NetEase's IR manager based in Hangzhou is also available for follow-up questions if you have any or you can always contact the Piacente Group for further information. The information for contact is located on the website and also on the press release. Have a great day and thank you.

Ladies and gentlemen, that does conclude our conference for today. If you would like to listen to replay of today's conference, you may do so by dialing 1800 406 7325 or international participants may dial 303 590 3030 and enter the access code of 456 9784#. We thank you all for your participant and at this time, you may now disconnect.