NetEase Inc (NTES) 2016 Q3 法說會逐字稿

Good day, everyone, and welcome to the NetEase Third Quarter 2016 Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Brandi Piacente. Please go ahead.

Thank you, operator. Please note that the discussion today will contain forward-looking statements relating to future performance of the Company and are intended to qualify for the Safe Harbor from liability as established by the U.S. Private Securities Litigation Reform Act.

Such statements are not guarantees of future performance and are subject to certain risks and uncertainties, assumptions and other factors. Some of these risks are beyond the Company's control and could cause 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 results, please see the third quarter 2016 financial results news release issued earlier today.

As a reminder, this conference is being recorded. In addition, an investor presentation and a webcast replay of this conference call will be available on the NetEase corporate website at ir.netease.com.

I will now turn the 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 these discussions, all percentages are based on renminbi.

Our ability to look toward the future has enabled us to build a dedicated community of followers, who counts on equality and innovations of our products and services. With our top of the line games and products, we furthered this growth in the third quarter, demonstrating improvements across each of our business lines.

Our total net revenues increased by 38.1% year-over-year led by our online game services segment which grew 26% followed by 23.8% revenues growth in advertising services and 107.2% growth in our email, e-commerce, and others segment.

Our mobile games continue to be among the industry's most popular games. In the third quarter, we introduced new chart-topping games that attracted a multitude of players.

Onmyoji, our latest 3D mobile experience became an instant success. Following it's release in early September, this exciting new game quickly surpassed our expectations and was rated as one of the top-grossing games in China's IOS app store, for both the Iphone and Ipad.

The popularity of our Fantasy Westward Journey and Westward Journey Online mobile games and the mobile versions of New Ghost also persisted in the third quarter. Other mobile games launched in the third quarter included Tianxia III mobile, Over Ocean, and Audition Mobile. These games were followed by the launch of HIT, a stunning new ARPG, in October, and we are planning to bring additional original titles in the near term to our growing mobile portfolio of over 100 games with titles including Heroes of Tang Dynasty Mobile, Demon Seals Mobile and Land of Glory.

Our PC-client games also delivered a steady performance in the third quarter. We continue to introduce new content and expansion packs for our leading games including Fantasy Westward Journey Online, which was formerly named Fantasy Westward Journey II, New Westward Journey Online II, New Westward Journey Online III, Heroes of Tang Dynasty Zero, Revelations, and New Ghost.

To further the life span of our most popular titles, we also launched new expansion packs for Kung Fu Master II and Demon Seals recently, and plan to launch new expansion packs in the upcoming months for games including Tianxia III and Heroes of Tang Dynasty Zero.

Blizzard Entertainment's Overwatch and Hearthstone: Heroes of Warcraft with its new adventure: One Night in Karazhan, continued to gain favor among Chinese audiences in the third quarter, demonstrating the universal strength of these world renowned brands.

Similarly, the latest expansion pack for Blizzard's World of Warcraft, Legion, has garnered considerable attention from players in China, surpassing our expectations since its September 1 release in mainland China."

Our competitive edge among the expanding internet technology industry remains strong as we work to develop new and improved products. More and more users are looking into interlink their online activities and connect with each other and we are driving to introduce innovative content and game play that improves this interconnectivity.

Some of the ways we can achieve this goal is through enhanced interactive communications from mobile users and by introducing virtual and augmented reality interfaces that further grow our community and improve players' experiences.

Turning to our advertising services business, we saw sequential and year-over-year revenue increases in the third quarter with the automobile, internet services and telecommunications sectors as our top performing verticals. There remains considerable opportunities with this business, and we are creating attractive options through our advertising partners with our industry leading mobile use app, and diversify mobile products, as well as high-profile events such as the 2016 Summer Olympics.

Additionally, our Kaola.com e-commerce offering continues to grow at a healthy pace. While our primary focus is on direct merchandise sales, we also look forward to maximizing the values of complementary services that extend the reach of this platform."

NetEase holds a rich history of innovations and growth. We believe that there remains significant opportunities for our company with exciting developments in the internet services marketplace where we hold considerable experience, with a track record of leadership and competitive R&D capabilities.

As we continue to grow our business, we remain focused on bringing our users premium internet products and services that capture their imaginations and keep them connected.

This concludes William's comments.

I will now provide a review of our third quarter 2016 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 2016 was RMB5.3 billion or $799.8 million, compared to RMB5.3 billion and RMB3.8 billion for the preceding quarter and the third quarter of 2015, respectively.

The year-over-year increase in online games gross profit was primarily driven by the revenue contributions from mobile games such as the Westward Journey Online mobile games, the mobile versions of New Ghost, and Blizzard Entertainment's Overwatch and World of Warcraft.

The year-over-year and quarter-over-quarter increases in advertising services gross profit were primarily attributable to strong demand from advertisers and our monetization efforts for the mobile applications primarily our Mobile News App.

The year-over-year and quarter-over-quarter increases in e-mail, e-commerce and others gross profit was primarily due to increased revenue contribution from our e-commerce business.

Our gross profit margin for the online games business for the third quarter of 2016 was 65%, compared to 66.2% and 67.9% for the preceding quarter and the third quarter of 2015, respectively.

The year-over-year decrease in gross profit margin was mainly due to increased revenue contributions from mobile games and licensed games which have relatively lower gross profit margins as a percentage of our total online game revenues.

The quarter-over-quarter decrease in gross profit margin was mainly due to increased revenue contributions from licensed games.

Our gross profit margin for the advertising services business for the third quarter of 2016 was 65.3%, compared to 65.5% and 67.6% for the preceding quarter and the third quarter of 2015, respectively.

The year-over-year decrease in gross profit margin was mainly due to higher staff-related costs and content purchase costs.

Our gross profit margin for the e-mail, e-commerce and others business for the third quarter of 2016 was 33.5%, compared to 33.8% and 0.1% for the preceding quarter and the third quarter of 2015, respectively.

The year-over-year increase in gross profit margin was primarily attributable to the business development and the gross profit margin improvement of NetEase's certain e-commerce businesses.

Our total operating expenses for the third quarter of 2016 were RMB2.5 billion or $372.9 million, compared to RMB2.2 billion and RMB1.8 billion for the preceding quarter and the third quarter of 2015, respectively.

The year-over-year and quarter-over-quarter increases in operating expenses were mainly due to higher staff-related costs resulting from an increase in headcount, average compensation, research and development investments and selling and marketing expenses.

We recorded a net income tax charge of RMB427.2 million or $64.1 million for the third quarter of 2016, compared to RMB262.7 million and RMB399.2 million for the preceding quarter and the third quarter of 2015, respectively.

The effective tax rate for the third quarter of 2016 was 13.3%, compared to 8.6% and 17.1% for the preceding quarter and the third quarter of 2015, respectively. The year-over-year and quarter-over-quarter changes in the effective tax rate was mainly due to the fact that certain of our subsidiaries were approved as Key Software Enterprises in the second quarter of 2016 and subject to a preferential tax rate of 10% for 2015.

We recognized the related tax credits in the second and third quarters of 2016. The effective tax rate represents certain estimates by us as to the tax obligations and benefits applicable to it in each quarter.

Net income attributable to the Company's shareholders for the third quarter of 2016 totaled RMB2.7 billion or $410.9 million, compared to RMB2.7 billion and RMB1.9 billion for the preceding quarter and the third quarter of 2015, respectively.

Non-GAAP net income attributable to the Company's shareholders for the third quarter of 2016 totaled RMB3.0 billion or $452.5 million, compared to RMB3.2 billion and RMB2.1 billion for the preceding quarter and the third quarter of 2015, respectively.

During the third quarter of 2016, we had a net foreign exchange gain of RMB14.8 million or $2.2 million, compared to net foreign exchange gains of RMB77.3 million and RMB66.5 million for the preceding quarter and the third quarter of 2015, respectively.

The net foreign exchange gains were mainly due to unrealized exchange gains and losses arising from our U.S. dollar-denominated bank deposits and short-term loan balances as the exchange rate of the U.S. dollar against the RMB fluctuated over the periods.

We reported basic and diluted earnings per ADS of $3.13 and $3.11, respectively, for the third quarter of 2016. This compares with basic and diluted earnings per ADS of $3.11 and $3.09, respectively, for the preceding quarter, and basic and diluted earnings per ADS of $2.15 and $2.13, respectively, for the third quarter of 2015.

Non-GAAP basic and diluted earnings per ADS were $3.45 and $3.42, respectively, for the third quarter of 2016. This compares with non-GAAP basic and diluted earnings per ADS of $3.68 and $3.66, respectively, in the preceding quarter, and non-GAAP basic and diluted earnings per ADS of $2.34 and $2.32, respectively, for the third quarter of 2015.

As of September 30, 2016, our total cash and cash equivalents, current and non-current time deposits and short-term investments balance totaled RMB32.1 billion or $4.8 billion, compared to RMB26.8 billion as of December 31, 2015. Cash flow generated from operating activities was RMB3.7 billion or $559.3 million for the third quarter of 2016, compared to RMB3.3 billion and RMB2.2 billion for the preceding quarter and the third quarter of 2015, respectively.

Our growth and success allows us to continue returning capital to our shareholders. As such, our Board of Directors has approved a dividend of $0.78 per ADS for the third quarter of 2016, the dividend is expected to be paid on December 2, 2016 to shareholders of record as of the close of business on November 25, 2016.

Also, as you may recall, on September 1, 2015, we announced that our Board of Directors approved a new share repurchase program of up to $500 million of our outstanding ADSs for a period not to exceed 12 months.

As of August 31, 2016, the last day to repurchase shares under this program, we have repurchased approximately 1.5 million ADSs for approximately $205.3 million under this program.

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

Thank you. (Operator Instructions).

We will take our first question from Eddie Leung with Merrill Lynch.

Hey, good morning. Just two quick questions. The first one is on the mobile game revenues. If I calculate correctly, it seems like there was a small decline sequentially in the third quarter for the segment. And we know that you launched a new game in September which is pretty successful.

So I was just wondering why there was a small decline in the revenues in the quarter sequentially?

And then secondly, just wondering what the increase in investment income in the third quarter? Thank you.

(Spoken in Mandarin).

(Spoken in Mandarin)

Eddie, with regard to your first question, so basically, although we appreciate the fact that we have launched the new games like Onmyoji in early September, like the second offer on the IOS platforms but the full platform launch only happened until towards the end of September 22 including the Android platforms.

So basically, you would appreciate that the full impact of those games contributions wouldn't be that apparent in the third quarter, and also there would also be certain deferred revenue that we have to account for such that the revenue would be amortizing the upcoming periods.

And with regard to William's projections and estimates about how our own gaming -- mobile games business would be performing in the upcoming quarters and the periods ahead, we are still quite confident on this front, because as always, NetEase has been very strong on this innovation front. Also we have also got a very strong strength in terms of exploring, about how to much better specialize in the mobile games arena and so we are still looking forward that we can upkeep our leading positions in the China market in terms of the mobile games development.

And so this basically would be the reasons to explain your first question.

And with regard to your second question, I believe that you will see that there has been an increase in terms of the investment income in the third quarter of 2016 versus the last quarter, there has been a loss, because if you recall, we have also made a kind of an investment and impairment provisions in the second quarter and this explains why the number has returned to a positive number in the third quarter.

Thank you very much.

Next, we'll move to Alicia Yap with Citi.

Good morning, William and Onward. Thanks for taking my questions. My question is related to your new game Onmyoji and so I wanted you to help us understand where are the incremental new users of Onmyoji come from, and also, based on your tracking and your big data, what is the percentage of overlaps of Onmyoji gamers to your existing games.

If there are some overlaps there, which games are most affected or cannibalized by Onmyoji? Is that the Fantasy or the Westward Journey? And then lastly, related to Onmyoji as well, with the October and November tracking, Onmyoji is now surpassing Fantasy mobile. Does that mean that we will experience some sequential decline for Fantasy revenues or Onmyoji actually helped to expand the entire gaming revenue's pie that we should not worry about Fantasy?

Thank you.

(Spoken in Mandarin).

So, basically, with regard to your question about the performance on our Onmyoji launch, basically we consider that this game by itself is a globally popular and -- a popular content, especially touching on the second generation stuff. So we have also been seeing that we have recorded quite a lot of successes on a worldwide basis, say, for example, in the Australia top-ranking (inaudible) has been -- came up in the top five positions, and whereas perhaps we can also share more data about its performance in other overseas markets like UK and US, of which we also believe that they have been performing very well so far.

On the other hand, we do see that, Onmyoji by itself is a game with a storyline that can tap into the interest for all the Chinese audiences on a global basis. Apart from pushing -- putting the games in the China market and some other overseas market, we are also looking at approach to explore also in the Japanese market as well. As always, we believe that this game has got a very high popularity amongst the Chinese audiences, and in the past one to two months' time of its launch in the market, we have been receiving very well and high received by the users and also high recognition by the players as well.

(Spoken in Mandarin).

Okay. Thank you.

So, another point that William would like to reiterate is that there is no need to be too much concerned about the launch of the Onmyoji with regard to a negative impact or cannibalize the existing games for our legacy game IPs like the Fantasy Westward Journey or Westward Journey Online, and even Ghost, because as a new product that we are designing, we would incorporate different and unique user experiences within it such that all the products that we launch in the markets will be complementary by themselves rather than cannibalizing one another.

Next we'll move to Jialong Shi with Nomura Securities.

Hi. Good morning, management. Thanks for taking my questions. I have two questions.

For your two legacy mobile blockbuster titles Fantasy Westward Journey and Westward Journey II, the ranking on App Store fluctuated through Q3, especially WWJ II. I just wonder, how do you view the traffic for both titles and how long do you think the lifecycle for these two titles may potentially last?

And also for Onmyoji, I just wonder when you will bring it to Japan? And are you working with Japanese publisher or you will operate the game by yourself in Japan? And I have a follow-up on e-commerce.

(Spoken in Mandarin).

(Spoken in Mandarin).

So, basically, with regard to your questions about the gaming front, first of all, William highlighted that, with regard to the user traffic in the third quarter, in fact we are still quite happy and confident to see that the active user base has been going up rather than what you see by referring to the top grossing charts that -- by seeing the ranking that it had been -- it has been volatile for some time.

Another thing that we'd like to reiterate is that NetEase should be the only one company on a worldwide basis that we possess the strength and ability to operate the gaming businesses on a very long-lasting manner. This can be revealed from the fact that we have been doing very good on the PC front and we also got the confidence that we can extend these capabilities and abilities to the mobile game front as well. And we are also in anticipation that in the upcoming five to ten years' time we would be able to roll out very good quality game products to the market that receive the highest user satisfaction that we are expecting.

On your second about the expected launch of Onmyoji in the Japanese market, so far we have not determined a definite timeframe, but in the meantime we will first make some more observations on how it has been doing in other overseas markets like Australia and New Zealand, and so far we have also been receiving very favorable and positive feedback from those areas as well.

Next we'll move to Fan Liu with Goldman Sachs.

Hi William, hi Onward. Thank you for taking my questions. So my question is very quick, just about revenue contribution for your mobile games. How much is from iOS platform and how much is from Android platform?

And also, could you please give us update of Overwatch?

(Spoken in Mandarin).

(Spoken in Mandarin).

Okay. So I'll get back to you on the part about the Overwatch performance lately. First of all, the Company has been very satisfied with its performance so far. One of the latest initiatives that we've been doing so far, doing promotions at the internet cafes where we have been encouraging some new users to try out the games without buying the CD key before. So they can -- this would also be a very effective way for us to develop a new group of users to participate in trying out these games.

On the other hand, we are also looking forward that, in terms of the future development of the Overwatch game, we will try to translate it into a more e-sport type of game on a global basis.

With regard to your question about the revenue contribution from our mobile games, on the iOS and Android platforms. Still up to the end of the third quarter, more than half of this contribution will still be coming from the iOS front.

Thank you, William and Onward.

Next we have Tian Hou with T.H. Capital.

Hi, William and Onward. I have a question related to your e-commerce, particularly the brand, the in-house brand, Yanxuan, I experienced some -- have some good experience of Yanxuan product, and I also noticed some of my friends also use Yanxuan product. So I wonder, what's your market position, what proposition for this part of the business with the relationship with the other part of e-commerce?

(Spoken in Mandarin).

(Spoken in Mandarin).

So, basically, William has made very comprehensive introductions and highlights about our positioning and our vision about how we would like to (technical difficulty) on the Yanxuan businesses. Basically all products that we are offering on the Yanxuan platform will be of the highest product design and manufacturing standards. And we are also engaging with some high-quality and proprietary PRC and also Japan factories in doing the production process.

As the name of our product line implies, we would be strictly selecting the best products for offerings to our targeted audience and customers. And our market positioning would be embracing three directions. First, a very competitive and good pricing. And second, offering the highest quality of products we are delivering to our customers, and the highest customer service.

One of the highlights that we have been doing so far is that we are offering a 30 days goods return policy without any reason, that no other peers in this space has been doing. We are the only one that offering this kind of incentive to our customers.

In terms of the product categories that we are currently covering, this would be including something like the household type of items, the stationary items, the kitchen stuff. Up to now we have about 500-plus SKU in place. We are also very encouraged with the fact that the goods return rate has been very low, of as low as 0.67% so far, which reflects that our customers are really very satisfied with the products and services we are offering so far.

Of course, NetEase also got a very huge and immense vision of running these platforms, and we would like to make a very well-planned technologies and products by -- and delivers those products to our targeted customers. And we also believe that this would only be just one thing that we are positioning ourselves as a NetEase product line, but this will be something that we will be proud to say from the country, the Chinese perspective, this will be a very good platform that we are servicing the customers, by offering them with the best products with very good price and quality and service. And all along, all the products that we are currently offering will be fulfilling some of the highest and the strictest industry standards like SGS and (inaudible) certification. So, all the customers who are using our products can have the full satisfaction and happiness.

Next we'll move to Natalie Wu with CICC.

Hi. Good morning, William, Onward, Juliet and Brandi. Thanks for taking my questions.

Firstly, congratulations on launching another mobile game title off your legacy. My question is regarding your mobile game business. Can management share with us what's the secret of Netease launching these games so [frequently/secretly]? And what do you expect regarding the lifecycle of Onmyoji? And what kind of title do you expect that can surprise us for another time after Onmyoji? So, [besides], what do you expect the mobile game industry competitive landscape will become several years later?

And also short term speaking, if my calculation is correct, your legacy mobile game FWJ and WWJ revenues experienced some kind of decline in the third quarter. So, just wondering if it's just a seasonal fluctuation or something else?

(Spoken in Mandarin).

(Spoken in Mandarin).

So when we look back in the past 15-plus years on NetEase business operations, NetEase does in fact got a very good and in-depth understanding about the PC gaming market and also a very good knowledge about the research and development front. We do see that FWJ and WJ has been growing very nicely in the past 15 years, owing to the fact that we have been a very strong game IP with good story lines and good quality of the content and user experience that we are offering to our targeted audiences.

Dating back in 2009, since the launch of the iPhone [4's] to the market, the Company has also taking a very proactive initiative to look into how this kind of changes will turn the market different in the years ahead. In fact, we have also been setting up over -- more -- intensive mobile studios in order to do the exploration, innovation and research on some new games, especially on the mobile front. And definitely, Onmyoji is one of those coming from those studios. We are also having the confidence that there will be lots of more similar games to come in the future periods.

For all the games that we are currently developing and launching to the market, we are targeting to the game enthusiasts, and for games like the Onmyoji that originally based on some Japanese (inaudible) that we are quite happy to see that this has also got a very good traction and reception from the market. And we will upkeep and continue our efforts to do our exploration, innovation for those very original [stuff] in the market.

(Spoken in Mandarin)

Another point that William would like to supplement is that in last year we have -- do another new initiatives about how we are marketing and promoting our existing games. One example would be our Ghost game titles that we are in collaborations with one of the TV shows in China which is called [Wei Bin Yi Xiao Hen Xing Xo]. This cross promotion effort has also proved to be very successful and also very effective in terms of bringing up the overall user base.

Since the start-up of the TV show since August 22, 2016 we have been seeing that the user number, the user base of the new Ghost mobile has been rising up very nicely to a few (inaudible) to the previous levels. We are also seeing that this games by itself has also received a very high user satisfaction (inaudible). This has also been reflected from the fact that the ranking in the top-grossing charts in the IOS China app store for the new Ghost mobile games has also been rising very nicely since then.

So we would just like to highlight and conclude that the DNA of NetEase is that we are very good at doing the innovations and exploration type of stuff for -- not only on the gaming fronts and for stuff like our new e-commerce initiatives like the Yanxuan we would like to try to explore a new way that we can position ourselves and to deliver some good stuff to our target audiences. For businesses like Yanxuan again we are targeting on good pricing, good qualities and also good service. This is all the way that we have been doing all along.

We'll take our final question from Hillman Chan with Macquarie.

Good morning William, Onward, Brandi and Juliet. Thank you for taking my question. I have a question regarding the e-commerce business. I notice that on our Duobao platform we are (inaudible) some of the high ticket items and also dropped (inaudible) as one of the payment methods. There may be some slowdown coming in the third quarter and fourth quarter.

I just wondered has more color on our strategy on Duobao business. Quickly on Kaola I notice that the inventory also sort of lagged quarter on quarter. Would that be due to low third quarter seasonality or something else? How should we think about outlook for the fourth quarter, for Kaola and future?

(Spoken in Mandarin)

(Spoken in Mandarin).

Basically whether you are talking about the Duobao or Kaola basically these would be different types of e-commerce selling more of the stuff we have been executing. For example on the Kaola front this would be focusing more on the overseas merchandise sales for items like cosmetics, that type of stuff and also women's accessories. This would somehow be complementary to our Yanxuan business model.

For the Kaola businesses of course we have also been in collaborations with other world famous and renowned brands like Costco where we have been procuring items like the [curling] appliance. Also we are in collaborations with Sasa, a cosmetic company in Hong Kong and also another one like the [E-mart] in Korea and also (inaudible) in Japan. Basically whether we are talking about the Kaola, Yanxuan or Duobao -- so basically we are just touching on the different types of e-commerce business models.

Okay, thank you William, Onward, Brandi and Juliet.

This concludes our question and answer session. I will turn the call back over to management for additional or closing remarks.

Thank you everyone for joining us today. If you have further questions please feel free to contact Juliet Yang, NetEase's IR manager based in Hangzhou or the Piacente Group Investor Relations. Thank you and have a wonderful day.

Everyone that does conclude our conference call. We do thank you all for your participation. You may now disconnect.