NetEase Inc (NTES) 2016 Q4 法說會逐字稿

Good day and welcome to the NetEase Fourth Quarter and Full Year 2016 Earnings Conference Call. Today's conference is being recorded.

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

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 fourth quarter and fiscal year 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. I would like to remind you that for the purposes of this discussion, all percentages are based on renminbi. Before we discuss the financials, I will provide some opening remarks from William.

Good morning, and thank you, all, for joining us on today's call. As one of the largest mobile game markets in the world, there is a massive appetite for premium game content throughout China. NetEase has been serving the growing online population for the past two decades, and now, it is a great honor to be one of the leading publishers in the mobile market where we strive to introduce premium game content to entertain and inspire our growing communities.

These are the efforts that have supported our growth across our business. In 2016, our total net revenues grew by 67.4% for the year and 53.1% in the fourth quarter, compared to the same quarter in 2015. For the fourth quarter, we saw year-over-year net revenue increases of 62.8% from our online games segment, 9.2% from advertising services segment, and 38.2% from our e-mail, e-commerce and others segment.

It is no surprise that our recent growth has been led by our accomplishments in the mobile market. In 2016, we introduced more than 40 new mobile games titles, including a number of chart toppers.

It is through our considerable focus and investments in R&D that enables NetEase to bring highly-desirable games to Chinese and the global players.

Our hit game, Onmyoji, has been widely embraced since its introduction in early September. It was named one of the top 10 outstanding games of 2016 in China's iOS app store.

We are very pleased with this game's early success and we see exciting opportunities to extend its popularity worldwide.

In December, we began to release Onmyoji internationally, beginning with Southeast Asia where it has been welcomed by a new wave of players. We expect to further broaden its reach with plans to bring Onmyoji to additional markets including Japan, Canada, Europe and the United States later this year.

Some of our other games that delivered excellent performances in the fourth quarter included our self-developed mobile games, Tianxia III mobile, and OverOcean, as well as HIT, a stunning new licensed ARPG. The mobile editions of Westward Journey Online, Fantasy Westward Journey and New Ghost also continued to be among our most popular games.

We recently released Demon Seals mobile and Heroes of Tang Dynasty mobile, both of which were well received. Other new mobile titles planned for near-term introduction include Westward Journey: Rage, which is an exciting ARPG edition of our legacy game to celebrate the 15th anniversary of this title, and a new innovative RPG called Treasure Hunter.

We will continue to build our formidable and diverse mobile portfolio where there remain ample opportunities for future growth. With over 100 mobile games, we plan to build on this momentum by introducing more mobile versions of our legacy titles as well as new self-developed and licensed mobile games.

We also have some strong showings from some of our PC client games in the fourth quarter including our flagship game, Fantasy Westward Journey Online. Our PC-client game continued to perform steadily and we released several new expansion packs during the fourth quarter -- Kung Fu Master II, Demon Seals, Tianxia III, Heroes of Tang Dynasty Zero and New Ghost to name a few. New expansion packs for Fantasy Westward Journey Online and Revelation were also recently released, and in the coming months, we plan to introduce a new expansion pack for New Westward Journey Online II.

Blizzard Entertainment's Overwatch, World of Warcraft, with its latest expansion pack Legion, and Hearthstone with its latest expansion pack Mean Streets of Gadgetzan also remained popular among loyal players in China eager for new content, and attracted new players.

Overwatch also established a new sales record in the category of buy-to-play PC-client games in mainland China, with more than 5 million copies sold by the end of December since its late May release. Furthermore, we are currently working to bring to Chinese players both PC and mobile versions of the highly anticipated, globally acclaimed game, Minecraft.

As more and more people gravitate towards a mobile lifestyle, there has been a dramatic shift in the way that overall data is consumed. An evolving advertising climate is a clear byproduct of these changes with mobile internet becoming one of China's primary advertising platforms.

As a comprehensive internet company, NetEase is well suited for this trend and our advertising services business continues to enjoy steady growth. Automobile, internet services and financial services were our top performing advertising verticals in the fourth quarter, supported by our industry-leading Mobile News App as well as high-profile events such as the 2016 NetEase Annual Economist Summit and the 2016 NetEase Annual Attitude Award Ceremony.

Additionally, our e-commerce business continues to thrive. Both Kaola.com and Yanxuan demonstrate a strong growth in the fourth quarter. This business is still in its development stage and we believe there is substantial opportunity here as these platforms mature.

We have a great deal to look forward to in 2017. We have always taken pride in providing innovative and outstanding products and services that reflect the needs of the exciting and ever-changing internet community. As we move through the year ahead, we will continue to populate China's internet markets with excellent mobile and PC games and online resources that support our growth and create values for all of our stakeholders.

This concludes William's comments.

I will now provide a review of our fourth quarter and fiscal year 2016 financial results. I will primarily focus on the discussions of margins and expense fluctuations along with net profit.

Our gross profit for the fourth quarter of 2016 was RMB6.5 billion or $930.9 million, compared to RMB5.3 billion and RMB4.2 billion for the preceding quarter and the fourth quarter of 2015, respectively.

The year-over-year increase in online games gross profit was primarily driven by increased revenue contribution from our mobile games such as Onmyoji and the mobile versions of New Ghost, as well as Blizzard Entertainment's Overwatch and World of Warcraft. The quarter-over-quarter increase in online game gross profit was primarily driven by increased revenue contribution from mobile games such as Onmyoji and the mobile version of New Ghost.

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

The year-over-year increase in e-mail, e-commerce and others gross profit was primarily due to increased revenue contributions from our e-commerce business, such as Kaola.com. The quarter-over-quarter decrease in e-mail, e-commerce and others gross profit was primarily due to decreased revenue contribution from certain e-commerce businesses with relatively higher gross profit margins.

The gross profit margin for our online games business in the fourth quarter was 60.7%, compared to 65.0% and 67.2% for the preceding quarter and the fourth quarters of 2015, respectively.

The quarter-over-quarter decrease in gross profit margin was mainly due to the one-off recognitions of certain royalty expenses related to licensed games in the fourth quarter of 2016, as well as increased revenue contribution from mobile games.

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 games revenues.

Gross profit margin for our advertising services business for the fourth quarter of 2016 was 66.5%, compared to 65.3% and 68.1% for the preceding quarter and the fourth quarter of 2015, respectively.

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

Gross profit margin for the e-mail, e-commerce and others business for the fourth quarter of 2016 was 23.4%, compared to 33.5% and 6.0% for the preceding quarter and the fourth quarter of 2015, respectively. The year-over-year and quarter-over-quarter changes in gross profit margin were primarily attributable to changes in our e-commerce business mix.

Total operating expenses for the fourth quarter of 2016 were RMB2.6 billion or $374 million, compared to RMB2.5 billion and RMB1.8 billion for the preceding quarter and the fourth quarter of 2015, respectively.

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

The quarter-over-quarter increase in operating expenses was mainly due to higher staff-related costs and research and development investments, which was partially offset by decreased selling and marketing expenses.

We recorded a net income tax charge of RMB882 million or $127 million for the fourth quarter of 2016, this compares to RMB427.2 million and RMB513.8 million for the preceding quarter and the fourth quarter of 2015, respectively. The effective tax rate for the fourth quarter of 2016 was 19.2%, compared to 13.3% and 19.2% for the preceding quarter and the fourth quarter of 2015, respectively.

The quarter-over-quarter change in the effective tax rate was mainly due to the fact that certain of our subsidiaries were approved as Key Software Enterprises in 2016 and subject to a preferential tax rate of 10% for 2015. We recognized certain related tax credits in the third quarter of 2016.

Net income attributable to the Company's shareholders for the fourth quarter of 2016 totaled RMB3.7 billion or $530.5 million, this compares to RMB2.7 billion and RMB2.2 billion for the preceding quarter and the fourth quarter of 2015, respectively.

Non-GAAP net income attributable to the Company's shareholders for the fourth quarter of 2016 totaled RMB4 billion or $569.9 million, this compares to RMB3 billion and RMB2.4 billion for the preceding quarter and the fourth quarter of 2015, respectively.

During the fourth quarter of 2016, we had a net foreign exchange gain of RMB90.5 million or $13 million, this compares to net foreign exchange gains of RMB14.8 million and RMB66.3 million for the preceding quarter and the fourth quarter of 2015, respectively.

These 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 $4.04 and $4.01, respectively, for the fourth quarter of 2016. This compares to basic and diluted earnings per ADS of $3.01 and US$2.99, respectively, for the preceding quarter, and $2.37 and $2.35, respectively, for the fourth quarter of 2015.

Non-GAAP basic and diluted earnings per ADS were $4.34 and $4.30, respectively, for the fourth quarter of 2016, this compares to non-GAAP basic and diluted earnings per ADS of $3.31 and $3.29, respectively, for the preceding quarter, and $2.58 and $2.56, respectively, for the fourth quarter of 2015.

Turning to our fiscal year 2016 financial results, our gross profit for the year was RMB21.7 billion or $3.1 billion, compared to RMB13.4 billion for the preceding fiscal year.

The increase in online game services gross profit in 2016 was primarily attributable to increased revenue contribution from our self-developed mobile games such as the Westward Journey Online and Fantasy Westward Journey mobile games, Onmyoji and the mobile version of New Ghost, as well as licensed games such as Blizzard Entertainment's Overwatch.

The increase in advertising services gross profit in 2016 was due to the monetization efforts for our mobile applications, primarily our Mobile News App. The top performing advertising verticals in fiscal year 2016 were automobile, internet services and telecommunication services.

The increase in e-mail, e-commerce and others gross profit in 2016 was primarily due to business development and gross profit margin improvement of certain e-commerce businesses.

Our total operating expenses for fiscal year 2016 were RMB9 billion or $1.3 billion, compared to RMB6.1 billion for the preceding fiscal year. The increase in operating expenses in 2016 was primarily due to increased selling and marketing expenses, higher research and development investments and higher staff-related costs resulting from an increase in headcount and average compensations.

We recorded a net income tax charge of RMB2.1 billion or $302.8 million and RMB1.3 billion for fiscal years 2016 and 2015, respectively. The effective tax rate was 15.1% for fiscal year 2016, compared to 15.7% for fiscal year 2015.

Our net income attributable to the Company's shareholders for fiscal year 2016 totaled RMB11.6 billion or $1.7 billion, this compares to RMB6.7 billion for the preceding fiscal year. Non-GAAP net income attributable to the Company's shareholders for fiscal year 2016 totaled RMB12.9 billion or $1.9 billion, compared to RMB7.4 billion for fiscal year 2015.

We have a net foreign exchange gain of RMB146.5 million or $21.1 million for fiscal year 2016, compared to RMB133.8 million for fiscal year 2015. The net foreign exchange gains were mainly due to unrealized exchange gains arising from our US dollar-denominated bank deposits and short-term loan balances as the exchange rate of the US dollar against the RMB fluctuated over these periods.

Our basic and diluted earnings per ADS for fiscal year 2016 were $12.73 and $12.63, respectively, this compares to basic and diluted earnings per ADS of $7.38 and $7.34, respectively, for fiscal year 2015.

Our non-GAAP basic and diluted earnings per ADS for fiscal year 2016 were $14.11 and $14.00, respectively, this compares to non-GAAP basic and diluted earnings per ADS of $8.13 and $8.08, respectively, for fiscal year 2015.

As of December 31, 2016, our cash and cash equivalents, current and non-current term deposits, and short term investments balance totaled RMB36.9 billion, or $5.3 billion, compared to RMB26.8 billion as of December 31, 2015.

Additionally, our cash flow generated from operating activities was RMB15.5 billion or $2.2 billion for fiscal year 2016 compared to RMB8.1 billion for the preceding fiscal year.

We remain committed to returning values to our shareholders and are pleased to announce that our Board of directors approved a dividend of $1.01 per ADS for the fourth quarter of 2016, which is expected to be paid on March 10, 2017 to shareholders of record as of the close of business on March 3, 2017.

Additionally, using our working capital, we repurchased approximately 1.5 million ADS for approximately $205.3 million in our previous share repurchase program that expired August 31, 2016.

To continue this trend, our Board approved a new 12 months share repurchase program beginning on November 15, 2016 for up to $1 billion. As of December 31, 2016, no ADS were repurchased 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, sir. (Operator Instructions)

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

Good morning. Congratulations on a very good quarter. Two questions on your mobile game business. The first one is more housekeeping. Could you give us some color on the contribution of mobile games within your online game revenue segment?

And then the second question is about the gross margins, besides the mix shifts to licensing games as well as mobile games, just wondering within mobile games, are we seeing a change in gross margin as well? And if so, what will be the reason? Thanks.

(Spoken in Mandarin)

Okay, so first of all, maybe regarding your first question about the mobile contributions for the game businesses up to the end of the fourth quarter, it has come up to 64% and with regards to the gross margins for the licensing and the mobile, I believe that it has also appeared to a relatively stable levels, but of course, if you compare to the overall gross margins for the game segments, the decrease was mainly due to the high contributions coming from the mobile games and also the licensed games.

Got that. Thank you.

And we'll go next to Natalie Wu with CICC.

Hi, good morning, William, Onward, Juliet and Brandi. Congratulations on a very strong quarter and thanks for taking my questions. Two questions from me. The first one is can management update us the recent development of Minecraft, including the launch date, monetization method, expectations, and also how to collaborate Minecraft with education?

And the second one is that can William show some color with us regarding the international expansion plan in the future?

(Spoken in Mandarin).

(Spoken in Mandarin).

So, with regard to your first question about the Minecraft development, so, basically William highlighted that, historically, there would be two games that got the highest revenue on a global basis. The number one would be the Tetris and the second one would be the Minecraft. And basically for the launch date for the -- our own Minecraft game title, we expect to launch it by July this year. And this would be a very unique version and different from the prevailing international versions that are currently in place.

And with regard to your second question about the international expansion plans, this is -- we have already got the plan to launch the Onmyoji Japanese version on February 23. Earlier then, we have already launched the game in some other areas like Taiwan, Hong Kong and also New Zealand. And all of those got the number one ranking on those iOS app store chart on those places. And coming along, we also expect to launch the English versions of the Onmyoji by May this year.

And at all times we believe that NetEase, by accumulating with over 15 to 16 years of game development experiences and with the fact that we have also got very strong capabilities to self-develop the games, and we are -- so expect that there would be more games to launch in the periods to come? And basically this would be our current plan about the international expansion.

We'll take our next question from Fan Liu with Goldman Sachs.

Morning, William, Onward and Juliet. Thanks for taking my question.

Could you please share with us what your expectation for the next new titles such as FWJ and WJ all this year? We know that you tend to add more game content and also launch more promotion campaigns for the titles. So just now maybe you can add some color on this front. Then I have a follow-up question.

(Spoken in Mandarin).

(Spoken in Mandarin).

(Spoken in Mandarin).

Sorry. Fan, maybe you just give me to recap in English very quickly.

So basically with regard to the expectations about the Company on two games, WJ and also FWJ, basically with a very long history of game development in the past 10 plus years, we do have very strong capabilities to deliver the highest quality and premium game to our players. And no matter we are talking about the PC and mobile games, we definitely would be able to deliver more new and innovative content to our targeted players and as well as to serve our fans with the highest quality and enabling them to experience the best [ever] content that they can from those games.

And early of the year we have also been implementing some try-outs on the AR technology. And going forward we would also be planning to incorporate this kind of features to our existing games like WJ and also the FWJ.

So, Fan, you can --

So my question -- yes, thank you. My second question is, we know that the e-commerce and e-mail and others saw a quarter-on-quarter decline on gross margin this quarter. So, may I know the reason behind that? Is that possible to have maybe a revenue breakdown between our (technical difficulty) business and also platform business if possible?

(Spoken in Mandarin).

Okay. So, Fan, maybe I will take this question. So, basically, this is quite obvious that in the past quarters there has been a drop in the revenue coming from the e-mail and e-commerce segments. And just as what we have also highlighted in the press release, because there are certain e-commerce businesses that have also been scaling down in the past quarters, of which they would possess a relatively higher gross margin, and that's why you will see that there has been a decrease in terms of the gross margin in the fourth quarter.

And in terms of the overall makeup of these segments, just as what we have also previously highlighted, I would say that a high portion of it will be coming from our e-commerce businesses like the Kaola.com and also Yanxuan.

And we'll take our next question from Jialong Shi with Nomura.

Hi. Good morning. Thanks for taking my questions. Congratulations on a very solid quarter. I have two quick questions.

First is about, we noticed there is a one-off royalty expense booked into your cost of sales in Q4. So I just wonder which again is this royalty expense for. Is it a new game or it is related to some existing games?

And also, I just wonder, for Kaola and Yanxuan, both business have seen quite strong growth in the past quarters, if we look at the next few quarters, should we expect to see the growth rate for Kaola and Yanxuan to slow down because of the rising base effect? And also, what is the trend for the margins of Kaola and Yanxuan over the next year?

I will translate the questions myself. (Spoken in Mandarin).

(Spoken in Mandarin).

So maybe I'll just recap your second question, about how we will launch the Kaola and Yanxuan development, especially in 2017.

So, basically, for both the Kaola and also the Yanxuan platforms, they are both very important to us as e-commerce businesses. For Kaola, basically we are doing huge and large volumes of purchases from overseas by ourselves, which in a way we can ensure the authenticity of the goods. And at the same time, we are also offering very good pricing to our customers who are purchasing from our Kaola.com platform.

In 2017, in terms of its growth expectations, we do anticipate that the growth rate will be much faster than the last year, which is 2016. And also, another point that we would like to reiterate is that the Kaola.com e-commerce platform is very unique by itself from all the other platforms who are doing similar businesses.

As for the Yanxuan businesses, basically we are adopting the ODM models and we are partnering with some very established, renowned and large factories who are producing still quality goods to our customers. And we are also making good use of this platform to deliver the highest values to our customers, especially the China customers who are buying those stuff. And in a way, they can have a very good experience from those buying experiences.

Going back to your previous question about the one-off recognition of the royalty expenses, this is related to some of our existing licensed games, and that's -- it has also come to the timing that we have to do it as a one-time treatment.

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

Congratulations to Ding-zong, Onward, Brandi, Juliet on a very strong quarter. I have two questions.

First one is that, regarding our overseas expansion, other than Onmyoji, could you also share more games in the pipeline that we want to bring to the overseas market? And in these overseas markets, what is our strategy to package the games? Are we publishing on our own or are we partnering with some local distributors?

(Spoken in Mandarin).

(Spoken in Mandarin).

So, basically, with regard to our overseas expansion plans, apart from the very good success that we have already made for Onmyoji, there are definitely some other games that we are also making good progress, things like the VR game which is called the Twilight Pioneers. And the other one which is the, in Chinese, which is (spoken in Mandarin) and we have also been rolling the overseas versions as well.

And we believe that in three to five years' time, based on our efforts, by expanding our footprint in the overseas markets, we do definitely got a much better development on that front.

Also on the VR and AR game pipeline, could you share more color for this year or next year? And when do you see the VR/AR market would kick off more meaningfully in China? And how do you see the barrier on (inaudible) as well?

(Spoken in Mandarin).

(Spoken in Mandarin).

So with regard to the Company's strategy on the VR and AR front, NetEase is definitely very serious in taking a leading role in terms of this development and the potential games rollout in the market. And earlier this year, in 2017, we have also embedded some AR features within our Onmyoji game, which also got a very good feedback from the market. In fact, on other games, which can be considered as our first VR game, which is called the Twilight Pioneers, that we have rolled on the Google platform, that have also been -- got a very good feedback so far.

We'll take our next question from Thomas Chong with BOC International.

Mr. Chong, your line is open. Please check your mute button on your phone.

Hi, William, Onward, Juliet. Thanks for taking my questions.

I have a question about Onmyoji, it's about, how should we think about the January performance versus the month of December? Because we see there are some marketing promotions for the games for other peers. So, are we seeing month-for-month trend in January?

(Spoken in Mandarin).

So I believe that, for now, because we would be focusing more on the year-end performance so far, and so we would perhaps give more color perhaps at a later stage.

Thanks, Onward. May I ask another follow-up question, it's about the online advertising trend? Is there any color about the sentiment this year? And how should we think about the growth rate in this year?

(Spoken in Mandarin).

(Spoken in Mandarin).

So there will be two parts of the responses that William would like to highlight. So with regard to the advertising services trend, so, basically the simple answer to it is that we are still expecting that there would be good growth in 2017 owing to the fact that we have quite comprehensive mobile applications in place. Apart from the mobile news application, we have our own Youdao Dictionary stuff, our -- and also the cloud music stuff. And all of those would be able to generate meaningful and good traffic there of which we can also enjoy a good growth in 2017.

And another point that William would like to highlight would be with regard to how we will improve this overall performances on the Onmyoji, because NetEase has been a company that has been -- built up very good capabilities of developing its own game. And things like -- games like the FWJ, WJ Online have already been operating for 15 years and they are still -- they're doing very successfully. Somehow this will be attributed to our strength in order to develop some very unique and premium content that can also fit the expectations of our targeted gamers and players. And in three to five years' time, we do see that, not only just the Onmyoji, there would be perhaps some more great titles to put into the market that can also be doing very good in the game business. And at the same time, we are also expecting that the Onmyoji wouldn't be -- would be following a similar trend that we have seen from the FWJ and WJ Online. That would also be very long-lasting game titles.

(Spoken in Mandarin).

Okay. So another supplement that William would also like to highlight is that with regard to how the performance of Onmyoji in January was, is that the overall spending, the consumption has also been rising in January this year.

And ladies and gentlemen, that is all the time we have for questions today. I'd like to turn the call back over to management for any closing remarks.

Thanks everybody for joining us. If you have further questions, you can feel free to contact us or Juliet Yang in Hangzhou for the Investor Relations. Thank you so much.

Ladies and gentlemen, this does conclude today's conference. We appreciate your participation.

Portions of this transcript that are marked (interpreted) were spoken by an interpreter present on the live call. The interpreter was provided by the Company sponsoring this Event.