NetEase Inc (NTES) 2015 Q2 法說會逐字稿

Good day, and welcome to the NetEase second-quarter 2015 earnings conference call. Today's conference is being recorded. At this time, I would like 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 20-F. The Company does not undertake any obligation to update this forward-looking information, except as required by law.

During today's call, management will also discuss certain non-GAAP financial measures for comparison purposes only. For a definition of non-GAAP financial measures and a reconciliation of GAAP to non-GAAP financial measures and results, please see the second quarter financial results news release issued earlier today.

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 call 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.

The rapid consumptions of mobile games is driving considerable growth in China's online games industry. With our long history as an internet innovator and some of the best R&D talent available, our strategy to expand into mobile, while still in its early stages, is beginning to take shape and contributing to our growth objectives.

Our strong second-quarter results reflect this success, with growth from both our PC clients and mobile games. In fact, we saw healthy revenue increases across all three of our business segments, both sequentially and year over year.

Compared with the same quarter in 2014, we saw revenue increases of 64.8% from online games, 22.8% from advertising services, and 123.3% from our e-mail, e-commerce and others business segment.

The diligent work we have put into expanding and diversifying our mobile portfolio is becoming more evident. We now operate more than 13 mobile games across a variety of genres to appeal to a broad and growing audience. And we plan to continue to build on this success.

We are delighted with our accomplishments during the second quarter. To name a few, our Fantasy Westward Journey mobile game reached a record peak concurrent user level of more than 2m in May. This game has performed extremely well and has been ranked as the top grossing app in the iOS China app store, since its launch in March of this year. As of July, it was the only mobile game in China with its own customized download page in the iOS app store.

For our PC client games, we were very pleased with the performances of some of our newest games, in particular, Revelation, our 3D oriental fantasy MMORPG, and our 2.5D MMORPG Demon Seals, which launched in April. Both of these games have been well received by users, with positive feedback.

During the second quarter, we also released expansion packs for New Westward Journey Online II and Ghost II, as well as conducted further beta testing for our 3D warfare MMORPG, Hegemon-King of Western Chu.

Our licensed games also fared well in the second quarter. We are very excited to be launching Blizzard Entertainment's Diablo III: Reaper of Souls in China, through the joint effort of Blizzard and NetEase, and with the incredible support of passionate Chinese players.

Additionally, the April launch of the mobile phone versions of Blizzard Entertainment's Hearthstone: Heroes of Warcraft helped drive that game's number of active users to a new high.

Lastly, Heroes of the Storm, Blizzard's brand new free-to-play online team brawler, began open beta testing in late -- in Blizzard's brand new -- sorry -- yes, okay, brand new free-to-play online team brawler began open beta testing in late May, followed by the game's official launch in early June, which had a promising performance.

We continue to work closely with Blizzard to introduce exciting new content to China and are thrilled to have licensed Overwatch, Blizzard's first-ever first-person shooter game.

Our pipeline of PC client and mobile games is strong and growing. Leveraging our strong research and development program, we plan to continue to introduce new games and content throughout the year. In July, we introduced a new expansion pack for our popular game, Tianxia III and are targeting a number of new expansion packs, later in the third quarter, for our self-developed games, including Fantasy Westward Journey II.

At the same time, we are expanding our portfolio of mobile games. Last month, we released several new titles that have been well received by users, including Fairy Tales: The World of the Brave, a licensed cartoon-style side-scrolling mobile game. In the coming months, we plan to release more mobile games based on our acclaimed self-developed franchises, including the Westward Journey Online mobile game, The X-World, an action-packed mobile ARPG game from the Tianxia universe, and Fantasy Westward Journey, Warriors: an exciting mobile action adventure game.

We continue to evaluate international markets opportunities. And our expansion plans are well underway to broaden our market's reach, through cross-country partnerships and licensing agreements, as well as independent sales. We have already licensed several of our mobile games to the Southeast Asia market, and our pipeline is focused on building mobile games for western audience. And the first of our mobile games for North American markets will be an adaptations for local markets of Speedy Ninja.

Turning to our advertising services business, this segment continued to perform well in the second quarter, driven by overall market demand and monetization efforts for our mobiles news applications. The top performing advertising verticals in the second quarter were the automobile, Internet services, and food and beverage sectors.

Additionally, our cross-border e-commerce platform, Kaola.com, experienced rapid growth in the second quarter and continues to gain user traction. This platform is still in its early stages, and we continue to broaden our capabilities by adding high-quality suppliers, increasing warehouse efficiencies and strengthening our overall brand equity.

We have built our Company on innovations and understanding the market, with an innate ability to evolve and adapt our technology to address market demands, such as increasing mobile accessibility. This flexibility supports our strateus to provide our community with exclusive and diverse products and services that meets their expanding needs.

We will continue to focus on creating top-quality new games for both PC clients and mobile users, and expanding our loyal user base. Our goal is to achieve balanced growth across our businesses by delivering exceptional products and services to our loyal and growing community.

This concludes William's comments. I would like provide a review of our second quarter 2015 financial results. I will primarily focus on the discussions of margins and expense fluctuations, along with net profit.

Total sales tax for the second quarter of 2015 were RMB265.2m, or $42.8m, compared to RMB225m and RMB184.4m for the preceding quarter and the second quarter of 2014, respectively. The year-over-year and quarter-over-quarter increases in sales tax were mainly due to the increase in our total revenues.

Gross profit for the second quarter of 2015 was RMB2.8b or $459m, compared to RMB2.5b and RMB2b for the preceding quarter and the second quarter of 2014 respectively.

The year-over-year and quarter-over-quarter increases in online games gross profit were primarily driven by revenue contribution from our mobile games, including the Fantasy Westward Journey mobile game, and licensed games such as Blizzard Entertainment's Diablo III, Hearthstone, Heroes of Warcraft, and Heroes of the Storm, as well as our new self-developed PC client games such as Revelation and Demon Seals.

The year-over-year increase in advertising services gross profit was primarily attributable to strong demand from the automobile, Internet services, and food and beverage sectors, and the monetization of our mobile applications, primarily our Mobile News app. The quarter-over-quarter increase in advertising services revenues and gross profit was primarily due to seasonality.

The year-over-year and quarter-over-quarter decreases in e-mail, e-commerce and others gross profit were primarily due to the temporary suspension of e-commerce services related to third-party lottery products since late February 2015, which was partially offset by increased revenue contribution from our cross-border e-commerce platform, Kaola.com and e-mail services, which have lower gross profit margins.

Our gross profit margins for the online games business for the second quarter of 2015 was 69.3%, compared to 73.1% and 77.6% for the preceding quarter and the second quarter of 2014, respectively. The year-over-year and quarter-over-quarter decreases in gross profit margins were mainly due to increased revenue contribution from mobile games, which have relatively lower gross profit margins, as a percentage of our total online game revenues.

Gross profit margins for the advertising services business for the second quarter of 2015 was 68.2%, compared to 59.2% and 60.9% for the preceding quarter and the second quarter of 2014, respectively. The year-over-year and quarter-over-quarter increases in gross profit margin were mainly due to enhanced economies of scale driven by revenue growth.

Gross profit margins for the e-mail, e-commerce and others business for the second quarter of 2015 was 4.2%, compared to 38.9% and 35.7% for the preceding quarter and the second quarter of 2014, respectively. The year-over-year and quarter-over-quarter decreases in gross profit margin were primarily attributable to the temporary suspensions of e-commerce services related to third-party lottery products discussed above, as well as increased revenue contribution from Kaola.com and our e-mail services, which have relatively lower gross profit margins.

Total operating expenses for the second quarter of 2015 were RMB1.4b, or $225m, compared to RMB1.2b and RMB823.7m for the preceding quarter and the second quarters of 2014, respectively. The year-over-year increase in operating expenses was mainly due to increased selling and marketing expenses for mobile and PC client games, and increased staff-related research and development costs, resulting from an increase in the number of employees and share-based compensation.

The quarter-over-quarter increase in operating expenses was mainly due to increased promotional costs for online games, which was partially offset by decreased promotional costs for the e-mail, e-commerce and others business.

We recorded a net income tax charge of RMB145.9m or $23.5m for the second quarter of 2015, compared to RMB214.5m and RMB97.9m for the preceding quarter and the second quarters of 2014, respectively.

The effective tax rate for the second quarter of 2015 was 9.2%, compared to 14.1% and 7.4% for the preceding quarter and the second quarter of 2014, respectively. The quarter-over-quarter decrease in the effective tax rate was mainly due to the Company recognizing certain tax credits in the second quarter of 2015 related to annual tax filing benefits, most of which comprise extra tax deductions for research and development expenses approved by the tax authorities.

We also had a net foreign exchange loss of RMB21.7m or $3.5m, compared to a net foreign exchange gain of RMB22.7m and a net foreign exchange loss of RMB20.2m for the preceding quarter and the second quarter of 2014, respectively. The quarter-over-quarter and year-over-year changes in foreign exchange gains and losses were mainly due to unrealized exchange gains and losses arising from our foreign currency-denominated bank deposits and short-term loan balances, as the exchange rate of the US dollar against the RMB fluctuated over the periods.

Our net income attributable to the Company's shareholders for the second quarter of 2015 totaled RMB1.4b or $229.7m, compared to RMB1.3b and RMB1.2b for the preceding quarter and the second quarter of 2014, respectively.

Non-GAAP net income attributable to the Company's shareholders for the second quarter of 2015 totaled RMB1.6b, or $256.4m, compared to RMB1.4b and RMB1.3b for the preceding quarter and the second quarter of 2014, respectively.

Basic and diluted earnings per ADS for the second quarter of 2015 were $1.75 and $1.74, respectively, for the second quarter of 2015. This compares to basic and diluted earnings per ADS of $1.56 and $1.55, respectively, for the preceding quarter, and $1.48 each for the second quarter of 2014.

Non-GAAP basic and diluted earnings per ADS were $1.95 and $1.94, respectively, for the second quarter of 2015. This compares to non-GAAP basic and diluted earnings per ADS of $1.75 and $1.74, respectively, in the preceding quarter, and $1.57 each, for the second quarter of 2014.

As of June 30, 2015, our total cash and time deposits balance was RMB20.7b or $3.3b, compared with RMB21.2b as of December 31, 2014. Cash flow generated from operating activities was RMB835.9m or $134.8m for the second quarter of 2015, compared to RMB1.9b and RMB1.2b for the preceding quarter and the second quarters of 2014, respectively.

As part of our efforts to return value to our shareholders, we are pleased to announce that in conjunction with our quarterly dividend policy, our Board of Directors has approved a dividend of $0.44 per ADS for the second quarter of 2015. We expect to pay this on September 4, 2015, to shareholders of record, as of the close of business on August 28, 2015.

Thank you for your attention. We would now like to open the call to your questions. Operator, please go ahead.

(Operator Instructions). Dick Wei, Credit Suisse.

Hi. Good morning. Thank you for taking my questions. I have two questions. First one is I wonder if William or Onward can talk a little bit more about the lifecycle for the Fantasy Westward Journey mobile game user. Given the strong growth in revenue, is it mainly coming still from the old user or we're seeing a lot of the new user coming on to play the games and contribute the revenue? So that's the first question.

And second question is we see pretty big increase in deferred revenue. I wonder if management can give like a mix of where the deferred revenue coming from, maybe by PC, mobile, or maybe from specific games as well. Thank you.

(Spoken in Chinese).

So with regard to Dick's first question about life cycles of FWJ mobile, basically we do see that since we first launched the games, dated back in early April, till now, about four months' time, the game itself has been ranked as number one, for almost 99% over the time period on the iOS apps -- China app store, which is very encouraging.

And basically, from the Company's perspective, we are quite satisfied with these product performances. And we are still -- uphold a very confidence mode with regards to its revenue contributions in the upcoming periods.

And based on our market research that has been undertaken so far, we have received very positive user feedback from the market. And we would uphold our business philosophies to deliver the highest qualities of products and the best-ever user experiences to our users, by rolling out or launching our mobile games. And we are also expecting that there will be some newer versions to enrich the contents and features of this game, so as to ensure that the user experiences can upkeep to the highest level at all times.

And in terms of the distributions of the user profile, basically around 70% of it would be coming from the new users, whereas the rest of the 30% would be coming from our existing PC client games users. And we are expecting that both for -- for both the new and old users, that they would be getting very good experiences of trying out these new mobile games. And this basically finished the first part on -- William's comments on the first questions.

And with regard to Dick's questions on the deferred revenue, and basically we do see that it has increased quite a bit in the second quarter. And basically we do see that there has been a good growth, in terms our mobile games initiatives that -- which have increased the deferred revenues. And we also see that for all our other games, there has also been a nice growth, in terms of the deferred revenues too.

Great. Thank you very much, William and Onward.

Alicia Yap, Barclays.

Hi. Good morning, William, Onward, and Brandi. Congratulations on the solid quarter. Thanks for taking my questions. I actually have a follow-up question from the deferred revenue. So I understand that it's related to FWJ and other games. Just wanted to know a little bit color, how long you would recognize the rest of those revenue? Is it for the following three quarters, for the maximum of 12 months?

And then can you give a little bit more color on the FWJ trend, since the launch in the end of March? Is the gross billing ramp up like month over month, or is it a big jump in April, and then kind of steady, and small growth for the months after that?

So first, I will just give you a first answer to your first questions about the deferred revenue. Basically, we do see that there has been a good increase, in terms of the revenue coming from the mobile front, as well as from our PC front. And as long as the -- how we are -- how long we are to recognize the revenue, it would still be -- depends on the consumptions of those different items, so to call. But basically, you wouldn't expect that this would take for a very long time.

And with regard to the second questions about the FWJ mobile trend, basically so far we are still seeing that it has been progressing well. And basically, the gross billings has also been up at very healthy levels. We do see that (inaudible) notice that since we first launched the mobile games of FWJ in the markets in late March or early April, it has been up-kept in the top ranking, in the iOS China app store for that long, which is a very good proof that you see that the game has been very popular among the users.

And we are also expecting that -- yes.

I see. And then -- and related to that, maybe can you share if there's some -- is there anything you have done differently to the game design and the game play that FWJ is able to achieve such an instant success? And given because relatively shorter lifecycle for all the mobile games so far, in other -- like other companies or other games, what your team is doing to keep the gamers' interest in the game. Any color you could provide would be helpful. Thank you.

(Spoken in Chinese).

So basically, in the -- the major highlights is that NetEase always puts the user experiences as the number-one task in order to achieve, and also to ensure that the users would get a best-ever experiences from trying out our different game titles.

And based on our fruitful experiences in the game development over the years, especially in the RPG games and also the item-based games, we do see that we have also accumulated a -- very good experiences to make sure that the development cycle has been going on well and smooth.

And the overall success of FWJ mobile, we will say that it would not be -- only lies on the fact that we have a strong IP or just going to the fact that we have some good past experiences, in terms of the self-developed games or the game operations. But more importantly, we do (inaudible) that how we put the attitudes towards the product itself and offering the best-ever user experiences to our users is of the most important point.

Thank you, Onward. (Spoken in Chinese), William.

Eddie Leung, Merrill Lynch.

Hi. Good morning. Thank you for taking my questions. Two questions. The first one is about your e-commerce business. I'm just wondering if management can share with us the key differentiation of your platform against a lot of your competitors. So what could be the advantage of NetEase running this Kaola platform?

And the second is just a housekeeping question on balance sheet. We noticed that there is also a pretty big jump in prepayment. So wondering if Onward could share some color on that. Thanks.

(Spoken in Chinese).

So basically, with regard to our differentiations from our peers in doing the cross-border e-commerce businesses, basically our Kaola.com business is a cross-border imported goods e-commerce business model. And basically, we are also focusing on our self-merchandising efforts to make sure that the highest qualities and the best stuff would be being sourced to our targeted users or consumers in the China market. And basically this would be the e-commerce platform.

And one of our main major features is that we are promoting the users to complete their transactions using their mobile applications. And in the upcoming periods we will also be adding in more new features to give a more refreshing feel to our users. And, as always, we are putting a very high importance of building up our own brand. And we are also regarding ourselves as having a very strong overseas merchandising capabilities on that front. That differentiates ourselves from our peers.

And with regard to Eddie's second question about the prepayments, the increase in the balance sheet, basically, you can -- we have -- this year we have been putting into our new business line, which is the Kaola.com, these cross-border e-commerce businesses. And we are also building up our own inventories to meet the demand of the local markets. And so one of the major increases in the prepayments and other current assets line items would be contributed from the increased inventory that we have built up so far.

Martin Bao, Bank of China International.

Hi. Thank you for taking my question. And I have two questions regarding the mobile games. The first one is how does the management think about the recent trend of the new gamers joining to the whole online game and the mobile game market. How does the Company will accommodate to the demand from these new gamers, such as the younger generation born in 1990s and the female gamers?

The second question is what's the criteria behind how do we choose to license the games and the external IPs besides our own IPs to develop or to license? (Spoken in Chinese).

(Spoken in Chinese).

So basically, with regard to our strategies in building up our new user base on the mobile game fronts, basically we are also emphasizing the importance of the new user group coming from the people born after 1990s or the 2000s. And one of the examples is that for our newly launched games, like the FWJ mobile versions, we have also engaged the TFBOYS, the band, to help to sing the songs for the game titles, which also got a very good reception there.

And with regard to the choice of the different new games targeted to perhaps to the female users and the younger generations, we will also be exploring whether there will be some more mature game titles or the game stuff than is available for us to roll out. And another game that we have lately trialed would be a game called the (inaudible).

And with regard to the choice of the games or the licensed games from the overseas markets, one of the points that we put at the highest priority is the quality of the games and how good those games can fit into the visual and also how good the play can be picked up by the targeted audiences. And in the -- very soon we will be rolling out another game that has been ranked as number one in the Korean market, which is called the Raven. And this is how we have been moving on, especially in the mobile game market.

(Spoken in Chinese). Thank you, Onward.

Thomas Chong, Citigroup.

Hi. Good morning. Thanks for taking my questions. I have a question regarding the online advertising. Can management comment about any impacts on the macro happenings? And on the other hand, any color about the revenue contribution coming from mobile? Thanks.

(Spoken in Chinese).

So basically, Thomas, with regard to your question about how we will approach our online advertising businesses' performances, we do not believe that the latest macro changes or some other methods have got a very significant impact to our business developments.

Thanks. And the other question is about the revenue contribution coming from mobile in online advertising.

The -- you mean the revenue contributions of the advertising --?

(Spoken in Chinese).

So basically, we have a very comprehensive strategy in setting out our global strategy. And apart from our mobile news applications we also have a very extensive work on other areas, like products like the cloud music, our Youdao Dictionary, the Cloudnote, the EaseRead and also the Lofter and as well as our Mail Master. All of those have been progressing very well and we do see that they have been -- the growth has been growing. And we anticipate that we perhaps we can share more colors about the distribution of revenue coming from the fronts versus the PC in the future period.

Hillman Chan, Macquarie.

Hello, William, Onward and Brandi. Congrats on a strong quarter. I have two questions. The first one is on your cross-border e-commerce. Could management give us more color on the growth plan for this business, for example, in terms of the SKUs or the categories and also your logistics deployment? And how should we think about your investment on this business going forward? And I have another question afterwards.

(Spoken in Chinese).

So basically, with regard to, Hillman, to your first question about our growth plan on our cross-border e-commerce, the Kaola.com businesses, first of all, this would be the imported goods e-commerce platform. And so basically, unlike the traditional e-commerce counterparts, we would need to put those stuff in a bonded warehouse or in overseas. And in order to address the warehousing issues, we would buy a warehouse to accommodate those inventories and also rent some warehouse in overseas. And at the same time, in terms of the SKU developments, we are targeting that the numbers will come up to 10,000 SKUs for this year.

And by the end of this month, which is August, we will also be launching another mobile application for the Kaola, which would give a more refreshing look to our targeted users. One of the competitive edges of our Kaolo.com businesses is that we place a very high importance of giving the good values to our users. And we believe that by doing so, the model itself would get the recognition from the users in a broader sense.

Just to quickly follow up on that, how should we think about the marketing dollar spend to promote, for example, our mobile app Kaola and also our webpage and also all these investments around your -- like warehousing in China or renting overseas. And if possible, just some color on profitability would be helpful. Thank you.

(Spoken in Chinese).

Yes. So basically, with regard to our anticipation or expectations of the spending on the marketing front, given the fact that NetEase got a very huge user base and given the fact that we are also selling quite a lot of the fast-moving consumables, we are expecting that our -- the marketing dollars that we are spending on this front, as compared with our peers in the space, will be lower.

And with regard to the potential investments in building up our own warehouse and stuff like that, basically this will be of a more similar magnitude to what everybody would be doing, the market, and basically the imports or the investment in those areas would be quite similar.

Okay. And my second question is on your strategy on licensing overseas games and IP to China. You recently announced your partnership with Netmarble, Raven and also your (inaudible) books. So when it comes to licensing all these overseas mobile games and IP, how should we look at the selection criteria? I think you touched on it previously. I just want to see some more color on how you see fit for Chinese gamers.

And what are the works that you've afterwards once you've licensed them. For example, localization, like renovation in terms of the game play and also the monetization models. And roughly how much -- how long time it takes from signing the deal to launching the games in China? This is my second question. Thank you.

(Spoken in Chinese).

So basically, NetEase has kept very close collaborations and relationships with the different game developers on a global basis. And so, given that those smooth and close relationships with the different developers and NetEase also contributing high recognitions from them, and on this front this can facilitate how we are going to proceed with different licensing arrangements. And whenever we need to consider and select particular games to license, definitely we would also be engaging our own team to perform some analysis of the different games, whether the features and the game content itself can fulfill our expectations. And we would also be considering whether those games would have a potential good response or demand in the China market. And this also reflects our responsible attitude towards serving our gaming community.

And on the other hand, you will also appreciate that we have also been getting into the game licensing business for quite a couple of years, since we first cooperated with Blizzard Entertainment some years before. And basically, we have a very happy and smooth relationship with Blizzard so far. And we also believe that we also possess the experience and the capabilities to make sure that for whatever new licensed game that we're going to do, the license fees or the royalties would be negotiated on very competitive terms.

Tian Hou, TH Capital.

Hi, William, Onward and Brandi. I have to ask several questions. Let's go with the first one. It's about your e-commerce. Regarding the e-commerce, so what's the take rate -- I think for this business you recognize the revenue as a GMV. So I wonder what's the take rate is today and what's the ideal level of the take rate for that business. That's the first question.

The second question is related to your -- the thought of this business, let's say, is totally different than game business. It's not game business. Game business is what you do really well, William. So now you're entering into a totally new business. And previously we saw Tencent enter into e-commerce and later on somehow [loaded] into JD.com. They don't do it anymore. So what makes you have such determination to do this business? That's the first question and then I will have a follow up.

(Spoken in Chinese).

So basically, we do regard that, if you look back in the past years on how we have been doing on our virtual product e-commerce business like the lottery product sales, we have been doing quite good and perhaps this will comparatively much better than our peers like the JD and stuff like that.

And basically, with regard to the cross-border e-commerce businesses, all the goods are located in overseas. And in the past years we do see that there has been a huge number of people and a huge amount being spent on that front of procuring the products in overseas. The reasons behind or the rationale is that people would believe that the products in those areas would offer a much better value for the monies that are being spent. And so we do believe that we do have a good relationship, especially with some overseas partners in this sense and on the premise that we are also taking care about the sourcing and merchandising by ourselves and making sure that the best values and also the highest quality products would be sourced, we can also stand up a very good competitive edge in doing this new business for ourselves.

Ladies and gentlemen, due to time constraints this concludes today's question and answer session. At this time I would like to turn the conference back to management for additional or closing remarks.

Thank you, once again, for joining us today. If you have any further questions, please feel free to contact Cassia Curran, NetEase's IR Manager based in Hangzhou, or the Piacente Group. Have a wonderful day.

This does conclude today's presentation. We thank you for your participation.