NetEase Inc (NTES) 2017 Q1 法說會逐字稿

Good day, and welcome to the NetEase First Quarter 2017 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, ma'am.

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 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 the reconciliation of GAAP to non-GAAP financial results, please see the first quarter 2017 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 corporate NetEase 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 start by providing opening remarks on behalf of William. As a reminder, all percentages are based on renminbi. 2017 is off to a strong start and our ability to successfully develop and distribute innovative content continues to be the cornerstone for our growth. Mobile has taken hold as the dominant force in the online community, and we are actively cultivating our mobile reach across our business to extend the NetEase brand to users not only in China, but around the world.

During the first quarter, we advanced a number of strategic initiatives in each of our core divisions, increasing our total net revenues by approximately 72.3% year-over-year and 12.7% quarter-over-quarter. Specifically, we introduced multiple new mobile games and added new expansion packs to our popular PC-client games. We also enhanced our monetization capabilities for our advertising services and expanded our e-commerce business. Led by our self-developed mobile games, the year-over-year increase of net revenues from our online game services was 78.5%. Net revenues from our advertising services and e-mail, e-commerce and other segment were also up by 13.2% and 63.2%, respectively, all compared to the same period last year.

Our mobile games continue to make greater contribution to our online game revenues. In the first quarter, mobile games accounted for approximately 73% of our total online games net revenues, up from about 64% in the preceding quarter as well as the first quarter of 2016.

We released a number of new mobile titles in the first quarter, including well-received games such as Demon Seals Mobile, Westward Journey: Rage and Land of Glory, an epic 3D western fantasy real-time MMORPG. These titles like Onmyoji continue to gain popularity with multiple content updates throughout the first quarter. And on February 20, 2017, it achieved 200 million global downloads. Other legacy mobile titles, including Fantasy Westward Journey and Westward Journey Online mobile games, Invincible, Heroes of Tang Dynasty mobile and the mobile version of New Ghost as well as the PC-client games such as New Ghost and Fantasy Westward Journey Online also maintained good user traction during the period.

We are also pleased to be expanding our global presence where NetEase-operated games are being widely embraced. In February, we released Onmyoji in Japan following its Southeast Asia release late last year. And we plan to continue our global rollout of this game this year with Korea, Canada, Europe and the U.S. as the next destinations. We have similar international aspirations with other self-developed games such as Land of Glory.

Popular games that we operate in China are also enriching the domestic online games market. In particular, the closed beta testing for Minecraft PC version launched in April is progressing well, and we are on track with the official launch planned for later this year. Additionally, for the first quarter, Blizzard Entertainment's Hearthstone achieved record number of quarterly active users and players are flocking to the game's newest expansion pack, Journey to Un'Goro launched last month.

A central theme to our game strategy is to explore various market segments while simultaneously attracting users to our legacy titles. We have a rich pipeline line-up for 2017 with a number of mobile games under development to strengthen and diversify our portfolio that includes more than 100 titles.

In April, we released several new mobile titles to positive user feedback including Treasure Hunter, a cartoon style TPS game or third-party shooting game. We plan to reveal more detailed pipeline information for the rest of the year at the NetEase game annual press conference on May 20, 2017, in Guangzhou.

With our PC-client games, we launched new expansion packs for New Ghost and Kung Fu Master II recently and plan to introduce new expansion packs for several popular games in the coming months, including Tianxia III, Heroes of Tang Dynasty Zero, Demon Seals, Revelation and New Westward Journey Online II.

The advertising and e-commerce markets are also core components of our growth. During the first quarter, the automobile, real estate and telecommunication services sectors were our top performing verticals with our year-over-year gains driven by strong growth in mobile media, supported by our top ranked Mobile News App. Additionally, both Kaola.com and Yanxuan are thriving with promising growth trajectories.

Our focus remains on creating premium contents for and enriching the imaginations of our massive community in online games, media and e-commerce. It is these ideas and strategies that support our ability to maintain our commitments to our shareholders, increase our profits and expand our company across each of our business lines. This concludes William's comments.

I will now provide a review of our first quarter 2017 financial results and primarily focus on margins, expense fluctuations and net profit.

Our gross profit for the first quarter was RMB 7.5 billion or USD 1.1 billion, compared to RMB 6.5 billion and RMB 4.6 billion for the preceding quarter and first quarter 2016, respectively.

The year-over-year increase in online games gross profit was primarily driven by revenue contributions from mobile games such as Onmyoji, the mobile version of New Ghost and Demon Seals mobile as well as Blizzard Entertainment's Overwatch and World of Warcraft. The quarter-over-quarter increase in online games gross profit was primarily driven by revenue contributions from mobile games such as Onmyoji, the mobile version of New Ghost and Demon Seals mobile. Quarter-over-quarter, we saw a decrease in advertising services gross profit, which was primarily due to seasonality.

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 businesses such as Kaola.com. The quarter-over-quarter decrease was primarily due to lower revenue contributions from certain e-commerce businesses with relatively higher gross profit margin.

First quarter gross profit margins for online games was 63.9% compared to 60.7% and 67.1% for the preceding quarter and the first quarter of 2016, respectively. The year-over-year decrease in gross profit margin was mainly due to increased revenue contributions from mobile games, which have relatively lower gross profit margins as a percentage of our total online games net revenues. The quarter-over-quarter increase was mainly due to decreased revenue contributions from licensed games which have relatively lower gross profit margins and one-off recognitions of certain royalty expenses related to licensed games in the fourth quarter of 2016, and partially offset by the increased revenue contributions from mobile games in the current quarter.

First quarter gross profit margins for the advertising services business was 57.3% compared to 66.5% and 62.4% for the preceding quarter and the first quarter 2016, respectively. The year-over-year decrease in gross profit margin was mainly due to higher staff-related and content purchase costs, and the quarter-over-quarter decrease was mainly due to seasonality.

First quarter gross profit margins for e-mail, e-commerce and others was 14.8% compared to 23.4% and 20.4% for the preceding quarter and the first quarter 2016, respectively. The year-over-year and quarter-over-quarter decreases were primarily attributable to decreased revenue contributions from certain e-commerce businesses with relatively higher gross profit margins.

Total operating expenses for the first quarter were RMB 2.7 billion or USD 394 million compared to RMB 2.6 billion and RMB 1.7 billion for the preceding quarter and the first quarter 2016, respectively. The year-over-year increase was mainly due to higher selling and marketing expenses related to online games, high R&D investments and high staff-related costs as well as operating expenses related to Kaola.com. The quarter-over-quarter increase was mainly due to higher staff-related costs.

During the first quarter, we recorded a net income tax charge of RMB 943 million or USD 137 million compared to RMB 882 million and RMB 530.7 million for the preceding quarter and the first quarter of 2016, respectively. The effective tax rate for the first quarter was 19% compared to 19.2% and 17.5% for the preceding quarter and the first quarter 2016, respectively. The change in effective tax rate represents our estimates for the first quarter of 2017.

Net income attributable to the company's shareholders for the first quarter totaled RMB 3.9 billion or USD 569.9 million compared to RMB 3.7 billion and RMB 2.5 billion for the preceding quarter and the first quarter 2016, respectively.

Non-GAAP net income attributable to the company's shareholders for the first quarter totaled RMB 4.3 billion or USD 630 million compared to RMB 4 billion and RMB 2.7 billion for the preceding quarter and the first quarter 2016, respectively.

During the quarter, we had a net foreign exchange loss of RMB 48.5 million or USD 7 million compared to a net foreign exchange gain of RMB 90.5 million and a net foreign exchange loss of RMB 36 million for the preceding quarter and the first quarter of 2016, respectively.

Our first quarter basic and diluted earnings per ADS were USD 4.33 and USD 4.29, respectively. This compares to basic and diluted earnings per ADS of USD 4.08 and USD 4.04, respectively, for the preceding quarter, and basic and diluted earnings per ADS of USD 2.72 and USD 2.7, respectively, for the first quarter 2016.

Our first quarter non-GAAP basic and diluted earnings per ADS were USD 4.79 and USD 4.75, respectively. This compares to non-GAAP basic and diluted earnings per ADS of USD 4.38 and USD 4.34, respectively, in the preceding quarter, and non-GAAP basic and diluted earnings per ADS of USD 2.94 and USD 2.92, respectively, for the first quarter of 2016.

As of March 31, 2017, our total cash and cash equivalents, current and noncurrent time deposits and short-term investments balance totaled RMB 40.6 billion or USD 5.9 billion compared to RMB 36.9 billion as of December 31, 2016. Cash flow generated from operating activities was RMB 4 billion or USD 585.7 million for the first quarter 2017 compared to RMB 5.4 billion and RMB 3.1 billion for the preceding quarter and the first quarter 2016, respectively.

As part of our commitments to return values to our shareholders, our Board of Directors approved a dividend of USD 1.08 per ADS for the first quarter of 2017, which is expected to be paid on June 2, 2017, to shareholders of record as of the close of business on May 26, 2017.

On November 15, 2016, the company announced that its Board of Directors approved a share repurchase program of up to USD 1 billion of the company's outstanding ADS for a period not to exceed 12 months. As of March 31, 2017, the company had repurchased approximately 83,000 ADS for approximately USD 23.7 million under this program.

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

(Operator Instructions) And our first question comes from Fan Liu with Goldman Sachs.

So your deferred revenues this quarter has declined by 8% quarter-on-quarter. Would you mind to guide the reason behind that? And also, do you mind to share with us what's your company's strategy to prolong the life longevity of the existing titles this year? And what's your plan on new product pipeline in the second half? And also, do you want to guide with us what's the revenue contributions for Kaola and Yanxuan this quarter? And also, any color on the margin profile will be also appreciated.

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(foreign language) So basically, with regard to your questions about how the company plans to maintain the longevity of the game products, the strategies that we are adopting, basically, you can make reference to what we have been doing in the past especially in the PC games front for, I would like to say game titles like FWJ or WJ II. You will see that we have accumulated quite good experiences and the knowledge about how to maintain a long life cycle for various game titles that we have operated for long. And in a way, you can also observe that through so many years, we have also been able to upkeep a very stable and perhaps a growing performance for those legacy game titles and a couple other game titles that we have put in place in the market. And we would definitely be making good use of those experience that we have accumulated over the years as well as adopting similar strategies for moving on to our mobile fronts. And we believe that those experiences will be very helpful to enable us to make sure that the same thing would happen on our mobile fronts. And on the other hand, we are also looking upon the fact that NetEase is a company very strong in delivering high-quality and premium game products into the marketplace. And we believe that by offering those good quality game products to the marketplace, this can also enhance the overall game experiences to our players or the gamers in general. And so we believe that this would also be another positive points that we would like to share with you. And on top of that, we have also got a very solid plan to roll out a couple of new quality and premium games to the market in the future periods. And so this basically would cover what William would like to share with you about how we think about our strategies to ensure the longevity of the game products.

And now getting back to your questions more on the financial side of the operations. I believe that in the first quarter, this is obvious that if you look at deferred revenues on a Q-on-Q comparison, there has been a drop of about 8%. But we do know that this is still a very understandable and also not a very significant decrease in terms of the deferred revenues. Because if you look back especially in the last quarter, because we already got a very high base in the fourth quarter, and in the first quarter of 2017, this is also being a quarter with not too many new games being rolled out. And so the drop is still quite within our expectations, and we are still feeling that all of our game titles are still doing good. And most of them are still keeping a very stable performance. At the same time, as and when we are rolling out some more new content updates or new expansion packs, we are also expecting that there will be a positive impact that brought about to the overall performances of our various other game titles in the marketplace. And so far as to your third question about the revenue contributions of Kaola businesses in our business segments, which is the e-mail, e-commerce and others, without giving you the exact percentages. I will say that in the first quarters of 2017, our e-commerce-related businesses, including both the Kaola and also our Yanxuan already accounts for a very significant portion of our overall revenue contributions in our business segment namely e-mail, commercial and others.

(Operator Instructions) And our next question comes from Alicia Yap with Citigroup.

My question is related to the fluctuations, recent fluctuations of Onmyoji. Is that mainly due to more intensified competition from other new games, or is that more related to Onmyoji on operation effort? And what would be the team currently working on to improve and overturn the fluctuations of the game? And then second question is related to Activision recently on their conference call. They noted that they saw about 30% year-over-year increase in the item sales for World of Warcraft and Overwatch. Do you see the similar type of growth rate for the China franchise for this game? Any color for that will be appreciated.

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(foreign language)

So basically, first of all, with regards to your first question about the Onmyoji's performance lately, definitely, we also see kind of some fluctuations in terms of performance. But after all, we still believe that the game by itself is a very successful mobile game. And we have a very strong team and high-quality products being rolled out to the market. And at the same time, we are very confident about our performance going forward because in terms of both the depth and the breadth of the contents that we are offering for these particular games, this is also still very good, and we have still lots to offer in the times to come. And so we believe that this game will still be performing well in the future. And on the other hand, with regards to how we realize the licensed games performances in particular to all the games that we have been licensed from Blizzard Entertainment, including -- not only including the World of Warcraft, Overwatch but also expanding to the Diablo III and also the Hearthstone and some other games as well -- and one of the highlights that we would like to share with you is that in the last week, it happens on the (inaudible) that all those games have also made another record high performances in terms of the user matrix that has been very encouraging to us. And we are still looking forward to that by offering some very quality products to the market. We still believe that this can also ensure a good user experience can be confirmed among our players, and this can also ensure a long-term performance of the games in the times to come.

Our next question comes from Natalie Wu with CICC.

So my question is about PC game. So I noticed that there's some kind of the softness regarding the self-developed PC games last year. So just wondering is it an issue to be worried about? Because PC game industry seems to be already sophisticated in China and cannibalization is taking place or -- and if NetEase is just confident to maintain the healthy development of PC game business, given your solid game operation experience. Just want to hear about management views on that.

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So with regard to your questions about the [competition] on PC game developments. Basically, we do believe that the user experiences being given to the PC games players cannot be fully replaced by just playing the mobile games in some ways. And in particular, especially for our licensed games that we license from places like the Overwatch, we have also been offering this game free-to-play to all the users. And in fact, last week, we also have been seeing that the games has also been reaching another record high that has been very encouraging to us. And in a much longer term, in terms of its market potentials, we still believe that the PC game still got these opportunities in the future periods. But of course, if you are talking about how we knew about its growth potentials, of course, we will be able to compare the rest with what the mobile games can offer. But after all, we always believe that for some outstanding products, both in terms of its qualities of the game play, the design, the contents that we operate and of course, how we are giving out the very unique user experiences when playing the games to our targeted users, we believe that this will be the areas that can offer the opportunities to further develop, especially in the PC game area. And after all, we always believe that the innovations and the abilities to create some new stops will be also very crucial to ensure a much longer-term success of the company, not only in the PC game front but also covering the whole games industry.

(foreign language)

(foreign language) Okay, another supplement that William would like to add is, in this year we would also be planning to roll out 2 more new PC games in the market. And in a way, this can also reflect that we are still looking good upon the potentials about the PC game developments going forward.

We'll take our next question from Tian Hou with T.H. Capital.

I have 2 questions. The first one is related to your game revenue like deferred revenue. Deferred revenue appeared in the balance sheet pretty often, and a lot of investors and also I, myself, feel a little bit confused about how you record your game revenue and how much growth revenue will be recorded in the current quarter, how much -- what percentage of that will be in the deferred? So that is one of the major questions. So I have a second question. In the seasonality, Q1 supposed to be the lower season for e-commerce, but to your e-commerce, it seems -- it has a up quarter. And I wonder what's the driver behind it? (foreign language)

(foreign language)

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So first of all, maybe I just get back to your questions about how we feel about the seasonality issues surrounding our e-commerce businesses in particular -- in the first quarter. First of all, the main part of it would be contributions from the Kaola businesses. And as you may be well aware of, this would be focusing on the overseas market and also depends on the prototypes that we are being selected and being offered to our targeted customers in the China market. And of course, more of the products would be women-focused, and we believe that the relatively good performances on our e-commerce businesses in the first quarters can be attributed to the fact that we have also been doing quite numbers of promotional sales during the period, and also we have been doing a little bit more marketing campaigns to promote the overall businesses, that can also bring up a positive impact to the overall performance for the e-commerce in the first quarter. And with regard to your second questions about the deferred revenue and stuff like that, I believe that we have always been reiterating that we have a standard accounting policy in order to amortize the revenues of our various game products for a period of not more than 6 months, and we have been following it all the way through in a consistent manner. And basically, we wouldn't be able to give you an exact percentages on how much of it will be recorded in the deferred revenues and how much will be in the revenues that we recognize. But we would be doing it on an overall basis. And also, it also varies from different game titles.

We'll take our next question from Jialong Shi with Nomura Securities.

(foreign language) Actually, I have 3 questions for the management. My first question is about Minecraft. I just wonder what is Minecraft's potential monetization model in China. And also I want to -- I would like management to share any colors on the revenue potential for this game in China. My second question is about Overwatch. Management mentioned earlier, Overwatch was free since May 1 this year. I just wonder if Overwatch may have some other revenue sources such as from the sales of virtual items? And my last question is about the quarterly dividend. The company has -- NetEase has a 25% dividend payout ratio, currently, I just wondered if management may consider raising the quarterly dividend payout ratio.

(foreign language)

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So getting back to your questions, Jialong, about the Minecraft. Basically, in China, there wouldn't be any copy sales as to what the overseas markets has been doing. In fact, the Minecraft that will be launched would be adopting the free-to-play model. And the current time lines that we're expecting to launch this game somewhere around the July time frame. And on your second question about the Overwatch. Basically, we would be adopting strategies to offer free-to-play to the users during the period from the 1st of May to the end of May, which is the 31st of May. And subject to the review after how the market would be reacting to this kind of arrangements, then there will be a chance that we will be extending it to a much longer period. And with regards to the monetization model or the business model that we are looking upon for the Overwatch product, basically, this will still be adopting the sales of virtual items within the games. And with regard to your third question about the dividend policies, I would say that for now, the company will still be quite happy with its current dividend payout ratio. But of course, the company and the board will be regularly reviewing the overall situations and consider all potential changes, whether we are talking about the further increase in terms of these dividend ratios in the future periods. But for now, we would still upkeep the current payout ratios at approximately 25%.

Our next question comes from Eddie Leung with Merrill Lynch.

Just a quick follow-up question on Minecraft. Wondering if you could share your thoughts with us on the target user segment of Minecraft. How is it going to be different than the current Chinese user base? (foreign language)

(foreign language)

So with regard to your questions about how we look upon the Minecraft especially the type of the users segment and how it would happen in China. First of all, I would like to share with you about some statistics or some previous track records in the past couple of years that the 2 of the most popular games in the market, the #1 will be Tetris, and the second one would be Minecraft. And in some ways, we also observed that in terms of the search index of searching the Minecraft games, this definitely would get a more than double search results than the #1 game. And insofar as the game is concerned about its launch and the operations in the China market, basically, we would be adopting a different model from the rest of the world, because in China, we will be offering that game free of charge to play, for the players. And we are also looking upon that with the many new contents and features that we are offering within these games. The rollout of the Minecraft into China would also be another successful one that we're expecting.

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

Regarding Minecraft, could you share more about the PC beta testing, articulate from that? And also, could you talk about the timeline for the mobile version of Minecraft in China? And my other question would be about e-commerce business. I noticed that we have been aggressive in Kaola, for example, going to Europe for big orders and also Yanxuan is also getting aggressive in China on procurement as well. Just wondering if you can share more on the growth outlook and also key entry target for this year, if possible? In the longer term, what's the margin profile that we should be expecting from this e-commerce business?

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So basically, with regard to the PC beta testing, we are feeling very happy with this performance so far, and everything has been progressing well. And in terms of when we are going to roll out the mobile version of the Minecraft, the anticipation will be somewhere around July of the year. (foreign language)

(foreign language)

So basically, we would like to share with you about how we roll out our strategies or the executions on our e-commerce business, especially on the Kaola and the Yanxuan fronts. For the Kaola, basically the reasons that NetEase would be getting into these new businesses is coming from 3 years before when the Chinese government has already opened the e-commerce businesses or, in fact, the cross-border e-commerce businesses to all the entrepreneurs in the China market, and we are making good use of this policy support in order to move into this new area. And in fact, there has been a slogan that we have always been talking about when we are undertaking the Kaola businesses because we are importing some overseas products, but the prices that we are offering will be just in local price, meaning that we are targeting and aiming to give a very good value for money to our targeted customers when they're buying some quality products from the overseas market. And insofar as the Europe market is concerned, of course, we have our own merchandising department out there, and we are also in close partnerships with some formerly new manufacturers like Danone and in Japan, we are also in close collaborations with Kao in order to offer some of the more popular items to our targeted customers. And on the other hand, when we look upon how we are moving to another area of doing the e-commerce businesses like the Yanxuan because we have been seeing that there has been a very good demand from the local markets for some good quality products in the marketplace and -- but many of the times, especially in the past, the people would be just doing its -- the product itself is being produced locally, but when they just place the brand name for some overseas markets then the price will be very expensive. But what we have been doing is that we are doing it by collaborating with manufacturers locally for some premium product or the brand names, and then we'll be just giving them money to find out certain designs because basically, for Yanxuan, the models that we have been adopting will be the ODM model. And there will be 2 things that we would like to offer to our targeted customers. First of all, quality product, and those will be something that they actually would like to have. And on the other hand, we are offering very good price to them. And insofar as the overall populations in China is concerned, because by now, China has already surpassed more than 1.3 billion people in China and this definitely will be a very huge market, and we do believe that in the future periods, that there will be a certain consumption upgrade, and we are also confident and also feeling proud that we will be one of the players, a leading player in the e-commerce area, especially on the Yanxuan front, by offering a very good quality products, but at a very cheap or very competitive price to our targeted customers and also, in terms of the user experiences because we are also adopting a very renowned and reputable logistic service provider like SF-express and we have also been getting very positive feedback from our customers so far.

And that concludes today's question-and-answer session. At this time, I'll turn the conference back to management for any additional or closing remarks.

Thank you, once again, for joining us today. If you have any further questions, please feel free to contact Juliet Yang, NetEase's Senior IR Manager, based on Hangzhou or TPG Investor Relations. Have a great day.

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