NetEase Inc (NTES) 2012 Q4 法說會逐字稿

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Ladies and gentlemen, thank you for standing by and welcome to the NetEase Incorporated fourth quarter and fiscal year 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 guarantees of future performance and are subject to certain risks and uncertainties, assumptions and other factors.

Some of these risks are beyond the Company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion.

A general discussion of the risk factors that could affect NetEase's business and financial results 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 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.

2012 was another strong year for our company with growth across our online games, portal and e-mail businesses. Throughout the year, we introduced enhancements to our online services and game offerings, as well as delivered new services, content and games to the market that build on our successful online platforms.

Our popular services and games continue to gain favor with the online community and our business continues to thrive. In 2012 we increased our total revenues by 12.1% to RMB8.4 billion, led by the outstanding performance of our self-developed games and growth from our advertising services business. We would like to note that we are very pleased with our year-over-year growth and financial results from our self-developed games business in 2012.

Remarkable growth from our self-developed games drove our 11.2% increase in online game revenues during 2012. Our flagship games continue to demonstrate encouraging performance and growth. Some of our highest performing games for the year included Fantasy Westward Journey and Westward Journey Online II, which both reached record high PCU levels in August, with Westward Journey Online II celebrating its 10-year anniversary in 2012. Ghost and Tianxia III also deliver solid performances during the year. Our newest games Kung Fu Master and Heroes of Tang Dynasty II, also received positive feedback and contributed to our increase in annual online game revenues.

We finished the year with solid fourth quarter total revenues of RMB2.3 billion, representing 8.3% growth year-over-year and a 13.8% increase quarter-over-quarter. Online game revenues for the fourth quarter increased 13.6% quarter-over-quarter, driven primarily by our self-developed games, including our three newest games Kung Fu Master, Soul of the Fighter and Heroes of Tang Dynasty II, as well as the launch of Blizzard Entertainment's World of Warcraft; Mists of Pandaria in October.

Kung Fu Master and Soul of the Fighter were released in October and September of 2012, respectively. While both games are still relatively new, we are pleased with their performance so far. The games are being well received by players and we will continue to enhance user experience for these games. Heroes of Tang Dynasty II has also performed well since its introduction on November 16th. This game is a comprehensive upgrade of Heroes of Tang Dynasty that builds on the strong user base of its already popular and long running predecessor.

As we look to 2013, we plan to continue on our growth path by introducing expansion packs and new content for our popular self-developed games, and bringing new games to China's online market. Robust game expansion and pipeline development continue to be a core theme for our online game services in 2013. By introducing exciting and high quality content, supported by well-timed promotional activities, we expect to further advance our growing portfolio of self-developed games that address evolving trends and user demands.

Our current release calendar calls for new expansion packs for Westward Journey Online III and New Fly for Fun in the first quarter, followed by expansion packs for Westward Journey Online II, Tianxia III, Heroes of Tang Dynasty II, Kung Fu Master and Soul of the Fighter, as well as a new version of Ghost in the second quarter. In addition to our schedules for expansion packs, we are actively developing new games to extend and diversify our portfolio. Our development efforts are progressing well and we expect to commercialize three new games in the second half of the year, including Heroes of Three Kingdoms, our 3D action real-time strategy game, Dragon Sword, our next generation 3D MMORPG, and Legend of Tibet, a 2.5D MMORPG that follows a unique story based on Tibetan mythology.

Turning to our advertising services, we increased the revenues by 6.8% quarter-over-quarter, led by the automobile, financial services and Internet services sectors. We continue to build on this business with a focus on further enhancements to our offerings. In particular, our mobile strategy is broadening our reach across an even larger audience. Our mobile initiatives are proving to be highly popular with users, and we have had great success with our mobile applications. As of December 31, 2012, we had over 50 million installations of our Mobile News application with over 22 million active users on a daily basis. 8.5 million installations for Youdao Cloudnote and 128 million installations for Youdao Dictionary, on mobile devices.

As we move through 2013, we are working to increase traffic to our portals, with a focus on both traditional and mobile Internet, and we are cautiously optimistic that we will see continued spending and growth from our advertising customers.

In addition, NetEase continues to be one of China's leading e-mail service providers. 2012 marked the 15th anniversary of our mailbox services and in August, we launched our new e-mail 5.0 services. The enhancements helped to drive a number of new users and substantially increased user activity for the year. As of December 31, 2012, we had approximately 530 million registered e-mail users. As we continue to optimize these services, we expect to further improve user appeal.

We see the opportunity to provide enhanced services across our businesses and continue to bring the online market the quality and innovation that is synonymous with the NetEase brand. In 2013, we will work to achieve continued growth through our strategic initiatives that underscore our commitment to driving content, community, communication and commerce in China's rapidly growing online market.

This concludes William's updates. Now I will provide a review of our fourth quarter and full year 2012 financial results. I will primarily focus on the discussions of margins and expense fluctuations along with net profit.

Beginning with the fourth quarter 2012 results, gross profit for the fourth quarter of 2012 was RMB1.6 billion, or $258.1 million. This compares to RMB1.4 billion and RMB1.5 billion for the preceding quarter and fourth quarter of 2011, respectively.

The quarter-over-quarter increase in gross profit was primarily attributable to increased revenues from both the online games and advertising services businesses. Revenues from our self-developed games increased during the period, mainly attributable to Tianxia III, Heroes of Tang Dynasty II, and our two new games, Kung Fu Master and Soul of the Fighter.

The performance of Fantasy Westward Journey, Westward Journey Online II and Ghost were steady in the fourth quarter of 2012. The increased revenues from licensed games were mainly due to the October 2012 launch in Mainland China of Mists of Pandaria, the fourth expansion for Blizzard Entertainment's World of Warcraft.

The quarter-over-quarter increase in gross profit from advertising services was primarily attributable to seasonality and reduced content cost due to high content cost incurred in the third quarter for the 2012 London Olympics. The year-over-year increase in gross profit was primarily attributable to greater revenues from our self-developed games, mainly Fantasy Westward Journey, Kung Fu Master and Soul of the Fighter. This increase was partially offset by decreased revenues from advertising services.

Gross profit margin for our online games business for the fourth quarter of 2012 was 75.3%, compared to 74.2% and 72.6% for the preceding quarter and the fourth quarter of 2011, respectively.

Gross profit margin for our advertising business for the fourth quarter of 2012 was 54.3%, compared to 36.3% and 54.5% for the preceding quarter and the fourth quarter of 2011, respectively. The quarter-over-quarter increase in gross profit margin was primarily due to increased revenues and reduced content costs, resulting from higher content costs incurred in the third quarter for the 2012 London Olympics.

Gross profit margin for the E-mail, WVAS and others business for the fourth quarter of 2012 was 13.0%, compared to 6.0% and 2.2% for the preceding quarter and the fourth quarter of 2011, respectively. The improvements in gross profit margin were mainly due to increased revenues from our e-commerce and mailbox businesses, as well as the sale of game-related accessories, such as a limited edition package of World of Warcraft.

Total operating expenses for the fourth quarter of 2012 were RMB580.4 million or $93.2 million, compared to RMB537.5 million and RMB529.0 million for the preceding quarter and the fourth quarter of 2011, respectively. The quarter-over-quarter increase in operating expenses was primarily due to increased selling and marketing expenses, mainly resulting from increased promotional activities for Kung Fu Master, World of Warcraft and Heroes of Tang Dynasty II, which was partially offset by decreased research and development costs, as we have recently commercially launched a number of new products. The year-over-year increase in operating expenses was primarily due to increased selling and marketing expenses and research and development staff-related costs, which was partially offset by an impairment provision of RMB50.3 million made in 2011 on the initial online game license fee of Blizzard Entertainment's StarCraft II.

Net profit for the fourth quarter of 2012 totaled RMB1.0 billion, or $161.9 million, compared to RMB811.9 million and RMB898.6 million for the preceding quarter and the fourth quarter of 2011 respectively. During the fourth quarter of 2012, we reported a net foreign exchange loss of RMB5.8 million or $0.9 million compared to a net foreign exchange gain of RMB23.7 million and a net foreign exchange loss of RMB36.4 million for the preceding quarter and the fourth quarter of 2011, respectively.  The quarter-over-quarter and year-over-year foreign exchange gains and losses were mainly due to the exchange gains and losses arising from our foreign currency denominated bank deposit balances as of December 31st, 2012, as the exchange rate of the Euro and US dollar against the RMB fluctuated over the periods.

We reported basic and diluted earnings per ADS of $1.23 each for the fourth quarter of 2012.  This compares with basic and diluted earnings per ADS of $0.99 each for the preceding quarter and basic and diluted earnings per ADS of $1.10 each for the fourth quarter of 2011.

We recorded a net income tax charge of RMB184.2 million or $29.6 million for the fourth quarter of 2012, compared to RMB194.8 million and RMB122.6 million for the preceding quarter and for the quarter of 2011, respectively.  The effective tax rate for the fourth quarter of 2012 was 15.4%, compared to 19.9% for the preceding quarter and 11.8% for the fourth quarter of 2011. The quarter-over-quarter decrease in the effective tax rate was due to the occurrence in the preceding quarter of a one-time accrued withholding tax of RMB40.0 million associated with the offshore remittance of cash from China in connection with the declaration of our special cash dividend.

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

Now, turning to the fiscal year 2012 financial results. Gross profit for fiscal year 2012 was RMB5.6 billion or $902.5 million, compared to RMB4.9 billion for the preceding fiscal year. The growth in revenues primarily drove the increase in gross profit for fiscal year 2012, which was partially offset by higher cost of revenues.

Total operating expenses for fiscal year 2012 were RMB1.9 billion or $306.8 million, compared to RMB1.6 billion for the preceding fiscal year. The increase in operating expenses in 2012 was primarily due to increased selling and marketing expenses, resulting from increased marketing and promotional activities for various games, including Kung Fu Master, Soul of the Fighter and Blizzard Entertainment's World of Warcraft, and increased staff-related costs resulting from greater headcount in general and administration and research and development areas. These increases were partially offset by the impairment provision of an initial online game license fee in 2011, as I previously noted.

Net profit for fiscal year 2012 totaled RMB3.6 billion or $583.9 million, compared to RMB3.2 billion for the preceding fiscal year. For fiscal year 2012, we reported a net foreign exchange loss of RMB0.6 million or $0.1 million. This compares to a net foreign exchange loss of RMB79.1 million for the preceding fiscal year. The net foreign exchange losses for 2012 and 2011 were mainly due to exchange losses arising from our Euro-denominated bank deposit balances as the exchange rate of the Euro against the RMB fluctuated over these periods.

We reported basic and diluted earnings per ADS of $4.45 and $4.44 for fiscal year 2012, respectively. This compares to basic and diluted earnings per ADS of $3.97 and $3.96 for the preceding fiscal year, respectively.

We recorded a net income tax charge of RMB691.6 million or $111.0 million and RMB392.8 million at an effective tax rate of 16.2% and 10.9% for fiscal years 2012 and 2011, respectively. The change in the effective tax rate was mainly due to the expiration of the tax exemption period for certain subsidiaries in 2012, the one-time accrued withholding tax of RMB40.0 million in 2012, as I previously mentioned, and a tax refund of RMB47.1 million that was received in 2011.

As of December 31st, 2012, our total cash and time deposit balance was RMB15.2 billion or $2.4 billion, compared to RMB11.9 billion as of December 31, 2011. Total held-to-maturity investments and other short-term investments balance was RMB1.1 billion or $172.3 million as of December 31, 2012. This compares to RMB993.6 million as of December 31, 2011.

Cash flow generated from operating activities was RMB4.2 billion, or $678.0 million for fiscal year 2012, compared to RMB4.1 billion for fiscal year 2011.

Finally, before we open the call to your questions, I would like to provide an update on the special cash dividend and share repurchase program, both of which were authorized by our board of directors in November 2012. The special cash dividend of $0.04 per ordinary share, which is equivalent to $1.00 per ADS amounted to approximately $131 million and was paid to shareholders of record as of January 15, 2013. Under our $100 million share repurchase program, as of December 31st, 2012, we have cumulatively purchased approximately 1.66 million ADSs in open market for a total consideration of approximately $67.2 million. The share repurchase program expires on November 20th, 2013.

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

Thank you. (Operator instructions) Our first question comes from the line of Richard Ji with Morgan Stanley. Please go ahead.

Hi William, good morning and happy Chinese New Year, in advance and also congrats on the solid quarter. I have two questions. First of all, let me start with English and then I will translate. Your new games have been performing well and including Ghost, Kung Fu Master and Soul of the Fighter. We understand usually you don't disclose the revenue breakdown of those games but can you help us understand a little better about their growth rates relative to the levels for your legacy games? Also, can you comment on the performance of these new games relative to your own expectations?

(Spoken in Chinese)

So basically, William's highlight with respect to Richard's questions is that from the Company's perspective, we are quite satisfied with the new game's growth and development and in particular for games like Kung Fu Master, which has been developed in the markets by the Company for six to seven years. The performance of the game so far in the markets has been encouraging and the Company would be more than willing to invest more resources to further develop the games in the market as well.

As for the other games like Ghost, it has also been performing well and we are also very satisfied with its performance so far. Stepping into 2013, the Company will also roll out more new games initiatives into new game areas and some of the games that we will be using will be taking a new theme like the 2.5D MMORPG Tibetan mythologies game that we are going to roll out, which is called Legends of Tibet and so I think we are looking forward to the new game developments in this year. Thank you.

Thank you. My second question is regarding your mobile Internet initiatives. You have deployed some very popular mobile apps such at NetEase Mobile News and Youdao et cetera. So for 2013, can you comment on your monetization plan as well as your mobile gaming strategy?

Okay, so basically, with regards to the Company's strategies in terms of the mobile Internet area, the Company's focus is very much on its strategies in exploiting our mobile Internet businesses and in 2013 we will also increase our efforts to roll out a full array of our mobile applications in different areas.

So far, I think other than the Mobile News, the Youdao Dictionary applications that have been in the market for some time, we have also been able to roll out some other popular applications like the Youdao Cloudnote, the (inaudible) and also the Cloud Music. Other than those applications kinds of stuff, we would also move forward into the mobile games area and we believe that everyone would get a better sense on how NetEase would position ourselves in this area, especially in 2013. Thank you.

Thank you.

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

Hi, thank you. Congratulations on a very good result of William and Onward. Maybe just quickly ask a question in Chinese and then I'll translate back in English. My question, firstly, what is the growth of the existing major two games in 2013 and the other question is what is the revenue contribution from the non-portal business of NetEase. Thank you.

(Spoken in Chinese)

So with regard to what was the first question, I think, with regards to the online game, business growth and performance for NetEase, I think, the focus should not be primarily on our legacy games like Fantasy Westward Journeys or Westward Journeys Online II. In fact, our -- for the Company, in the last five years, we have also made other achievements or rollouts with some new initiatives by rolling out some new games in the market; like Tianxia III, Ghost, Heroes of Tang Dynasty II, Kung Fu Master and all of those new games has also been some experienced very successful launch, good user receptions and we also see that those new games has also contributed a good result that can be reflected in our financials.

With regards to Wallace's questions on the revenue contribution on our other non-portal businesses, I think for NetEase, we are very focused on our user experiences and especially in the mobile internet areas, we have also roll out some new initiatives, like the news, the new reader, the movie tickets applications and many, many other things. We also see that those initiatives were mainly to improve the user experiences and to also able to establish a platforms to enable people to get the information more timely and in terms of revenue contributions, we do see that in the short term, it would not be contributing too much revenues to our overall businesses, but the more important point is that we will try to improve the user experiences and also to build a good user base from there. Then, we will see how we further develop the businesses going forward.

So what is the plan for the new expansions known for the Fantasy Westward Journey and Westward Journey II? Thank you.

(Spoken in Chinese)

Well, William, maybe I can also add some rough estimations based on the Company's current expectations, because usually both those legacy games, the rollout of the new expansion packs will be somewhere around in the second half, the second quarters to first quarters of the year, but usually we would do some advance announcement before the rollout of those expansion packs. So you can do these kind of estimations for now.

Thank you.

Thank you. Our next question comes from the line of Dick Wei from J.P. Morgan. Please go ahead.

Hi. Congratulations on a very strong quarter. So I have two questions. First question is, I think, a last quarter World of Warcraft and Tianxia III and - has pretty good growth. I wonder if you can comment on this quarter. In the first quarter, what is the momentum for the two games? Also, the second question is on gross margin. What are the key reasons for gross margin increase? What is the main reason? Is the game mix moving more towards the in house developed games?

With regards to this first question, first of all, for Tianxia III, this one is a self-developed 3D MMORPG games, adopting the other base model and over the time, we have enhanced this contents and user experiences with lots of investment in terms of R&D and we will upkeep those efforts in order to improve the product itself and in order to make it perform well in the market and excel in the industry. For the World of Warcraft, I think basically, the launch of the fourth expansion pack with some China elements was in October and the initial (inaudible) and we're still looking forward that in the upcoming period, there would be more regular launch of new elements or expansion packs or new game play in order to enrich the user experiences for the World of Warcraft.

With regards to next -- second question about the gross margins increase for the game businesses, I think it is quite right in saying that it is mainly a result of the change in the game mix that we have got a higher portion of the revenues coming from our self- developed games.

Great. Thank you very much.

Thank you. Our next question comes from the line of Alicia Yap from Barclays Capital. Please go ahead.

Good morning, William, Onward and Brandi. Thanks for taking my questions. My first question is regarding mobile games market. So I wonder if William can share his view on the mobile games market potential in China and if this year, whether we will see the inflection points for mobile games to take off more meaningfully for many games company and for your own mobile games strategy, just can you comment whether it will be more on those, like, charge per download or on the virtual item selling model? Thank you.

(Spoken in Chinese)

So basically, William's views about the mobile game market potential is that we also host a positive view about this part of the game market. We also emphasis the importance of further expanding into this area. For this year, we would also put in more efforts in terms of researching and developing new initiatives, but of course, it would also take some time, but we would look forward to it.

I see. Thank you. My second question - yes, my second—

(Spoken in Chinese)

Okay. So there is also one supplement that William would also like to share about his will on the mobile game market developments. Basically, we will also see quite a lot of successful experiences in countries like the Korea, Japan, US and also Europe. Basically, for the mobile games development, in terms of development requirements, it's much easier to do so and for NetEase we have accumulated quite a lot of valuable experiences in the games development areas and so, we do look forward that we will be able to work out something meaningful in the upcoming future.

I see. Thank you for the very detailed answer. Can I just follow up and can William share his view on whether -- on the mobile games takeoff, will there be any cannibalizations on the user traffic or the, you know, kind of like the revenue performance for the existing MMO games in the future?

(interpreted) So basically, we do not reveal the rollout of any mobile games initiatives without any cannibalization issues on our user base for the client based games.

Great. Thank you so much.

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

Good morning, William and Onward. Thank you for taking my question. Two questions. The first one is about your (inaudible). Could you share with us your plans on licensing fees for this year? Then, secondly, about your portal business, do you expect desktop traffic growth would be fairly slow or even stopped this year and if so, what's the plan to handle these changes? Thank you.

(interpreted) So with regard to answer his first questions about the Company's plan for licensing games in this year, I think basically the Company's would be upholding an open attitudes to it and if we could actually identify some good products in the market, with good content and reasonable price, I think we would actively consider all this kind of initiatives and to consider licensing those new games.

For the second question about the potential impact on the desktop traffic growth, I think, basically, I think that William's view is that there wouldn't be any big changes to the desktop traffic, even though we have made much more effort in rolling out more mobile initiatives. Say for example, for our desktop initiatives, we have a very good product, which is the Mailbox which itself is sticky to the users.

Through so many periods of time, we have also enhanced and increased our users' experiences by rolling out some new products. The latest one, like the news read, is also one of those that can also enhance the user experiences. At the same time, what we will say about the mobile internet development is that it is not replacing what we are currently doing on the desktop on our existing portal, but rather, we would consider it as an expansion and supplement to our existing portal business strategies. Maybe, the initial rollout of the mobile initiatives will have some impact to the desktop traffic or so, but in the long term, we do see that those two platforms or those two initiatives would be quite complementary, rather than replacing one to the other.

(Spoken in Chinese)

So basically, other things that William would like to supplement is that in this year, for NetEase, we would further increase our investments in terms of the contents delivery and one of the initiatives that we have lately rolled out is the cloud music. We do see that we would try to make this available to both the users on the mobile platforms as well as on the PC platforms. This is also a very good application by itself to share some good (inaudible) with the users on these applications. At the same time, we would also do more meaningful stuff on our news read products, by having more independent writers to contribute stuff on these platforms, in order to enhance the reading or the user experiences as such.

In fact, for this year, for NetEase, we would also upkeep our commitments to invest more, to buy more good quality contents, like the books, the online videos and things like that. One more point that we would like to supplement with that, we've also got our open education applications, which is available on both the PC and also the mobile platforms.

Got it. Thank you.

Thank you. That's all the time that we have for questions. I would now like to turn the conference back over to the speaker for closing comments.

Thank you once again for joining us today. Please feel free to contact Cassia Curran, NetEase's IR manager based in Hangzhou, or The Piacente Group Investor Relations if you have further questions. Have a wonderful day and Happy New Year.

Ladies and gentlemen, this does conclude our conference for today. This conference will be available for replay until February 21st, 2013 at midnight. You may access the replay system at any time by dialing 1800 406 7325 or international participants 403 590 3030 and enter the access code of 4588210#. We thank you for your participation and at this time, you may now disconnect.