NetEase Inc (NTES) 2017 Q2 法說會逐字稿

Good day, and welcome to the NetEase Second Quarter 2017 Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Ms. 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 these 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 a non-GAAP financial measure and reconciliation of GAAP to non-GAAP financial results, please see the 2017 second quarter financial results 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. Charles Yang, Chief Financial Officer, who will read the prepared remarks on behalf of Mr. William Ding, Chief Executive Officer of NetEase.

Thank you, Brandi, and thank you, everyone, for participating in today's call. I would like to start by saying that I'm very, very excited to join NetEase. For the past decade, my career has been dedicated to corporate finance and investment banking with a focus on China's TMT sector. Like many of you, I have followed NetEase for some time, both personally and professionally, and it is a great honor to join a great company and becoming a part of this reputable management team.

Before we begin, I would like to remind everyone that all percentages are based on renminbi. With that said, I'm pleased to deliver opening remarks on William's behalf.

Providing people with outstanding services and products is the heart of our business. With each piece of new content that we introduce, we are keeping our community connected and engaged, and our business is thriving.

During the second quarter, our net revenues grew almost 50% compared with the same period last year. Our net revenue for our online game services grew 46.5% year-over-year, led by our self-developed mobile games. These remain our primary growth engine, accounting for 72.4% of our online game services net revenue in the second quarter.

Looking at our game portfolio, the popularity of many legacy titles continues to be strong. During the second quarter, our PC-client game, Fantasy Westward Journey Online, and mobile game, Invincible, reached record-high quarterly revenues. We also saw positive momentum from Fantasy Westward Journey and Westward Journey mobile games as well as the mobile version of New Ghost. In addition to new content for our legacy titles, we launched a number of new mobile games to enthusiastic audiences during the second quarter, including Land of Glory and Treasure Hunter, both of which were very well received.

In mid-July, we also brought Crusaders of Light to the U.S., that's the international version of Land of Glory, and we are pleased with the initial reception.

While we saw some pullbacks from Onmyoji, this is within the management's expectation given the title's huge success with players since its launch late last year. We see this as part of the natural ebb and flow while our players still crave for new content. The latest content update "Fireworks Festival", was well received once released at the end of July. We plan to frequently launch high-quality content update to meet players' growing appetite. Additionally, to leverage its strong IP, we've launched a media strategy to expand the brand influences, and Onmyoji continues to increase in popularity among players internationally.

During the second quarter, Onmyoji reached record-high downloads in Japan and Southeast Asia. We are continuing to expand its reach and plan to bring this popular mobile RPG to players in Korea, Canada, Europe and the U.S. later this year. Onmyoji has already reached record-high preregistration levels with our licensing partner in Korea, and the release on Facebook's Gameroom platform is further fortifying this game's overseas presence.

While we bring our community new exciting content and games, we are simultaneously exploring creative market segments where we see complementary growth opportunities. Producing games for additional platforms and adding new gameplay capabilities such as VR and AR enables us to leverage our strong and innovative R&D competencies and employ our pioneering spirit.

At the end of the second quarter, we released Twilight Spirits, our first title for the Steam platform. Initial feedback has been positive, and we will look for other opportunities where we can expand our reach. We also continue to invest in VR- and AR-related projects and are exploring investment opportunities in both hardware manufacturers and content developers.

Our mobile portfolio currently stands as one of the most robust in China. We intend to grow this business, with current plans to introduce new titles and content that support our position. We have an exciting pipeline of upcoming games for the third quarter. We have already released a handful of titles, and on July 21, we began closed beta testing for PC-client game Open Range. We are also moving forward with the highly anticipated sandbox game Minecraft. We initiated open beta testing for the PC version on August 8 and plan to roll out our initial beta testing for Minecraft mobile version soon. Our primary focus during this initial stage will be to attract users and development partners.

Other new upcoming games include Index and Forever 7, 2 exciting Japanese themed RPGs; and the stunning 3D PC-client game, Conqueror's Blade, which was formerly known as War Rage.

In addition to our leading position in China's online games market, we are expanding our global footprint as we see ample opportunity to grow our brand and bring more of our games to overseas markets.

Now turning on to our other business segments. Our net revenues from advertising services increased by 12.1% compared to the same period last year, supported by our award-winning NetEase News App. Automobile, Internet services and real estate services segment were the top performing verticals. Mobile advertising continues to rise as the preferred means of advertising, which bodes well for us, as we hold considerable mobile reach with our users.

Our e-mail, e-commerce and others business segment also increased in the second quarter, growing by 68.9% compared to the same period last year. E-commerce, in particular, is becoming an increasingly important revenue contributor. Kaola and Yanxuan are flourishing among a market ripe for high-quality products, and both of them did quite well during the June 18 sales event.

We continue to invest in our future development. We are introducing exciting new games and services that continue to strengthen and diversify our portfolio, support our ability to broaden our reach within our expanding community worldwide and continue to grow each of our business lines.

This concludes William's comments.

I will now provide a review of our second quarter 2017 financial results. As in past quarters, the discussion will primarily focus on margins, expense fluctuations and net profit.

Our gross margin for the second quarter was CNY 6.7 billion or USD 993.7 million compared with CNY 7.5 billion and CNY 5.3 billion for the preceding quarter and the second quarter of 2016, respectively. The year-over-year 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 quarter-over-quarter decrease in online game gross profit was primarily due to decreased revenue contribution from mobile games.

The year-over-year increase in advertising services gross profit was primarily due to our enhanced monetization efforts. The quarter-over-quarter increase in advertising services gross profit was primarily due to seasonality. The year-over-year 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.

Gross profit margin for our online game business for the second quarter of 2017 was 63.1%. This compares with 63.9% and 66.2% for the preceding quarter and the second quarter of 2016, respectively. The year-over-year decrease in gross profit margin was mainly due to increased revenue contribution from mobile games, which have relatively lower gross profit margins as a percentage of our total online game services net revenues.

Gross profit margin for our advertising services business for the second quarter of 2017 was 67.6%. This compares with 57.3% and 65.5% for the preceding quarter and the second quarter of 2016, respectively. The year-over-year increase in gross profit margin was mainly due to our enhanced monetization efforts. The quarter-over-quarter increase in gross profit margin was mainly due to seasonality.

Gross profit margin for our e-mail, e-commerce and others businesses for the second quarter of 2017 was 11.3%. This compares with 14.8% and 33.8% for the preceding quarter and the second quarter of 2016, 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 second quarter of 2017 were CNY 3.3 billion or USD 491.4 million compared with CNY 2.7 billion and CNY 2.2 billion for the preceding quarter and the second quarter of 2016, 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 and average compensation, increased selling and marketing expenses mainly related to online games and increased operating expenses related to our e-commerce businesses.

For the second quarter of 2017, we incurred a net income tax charge of CNY 703.5 million or USD 103.8 million. This compares with CNY 943.0 million and CNY 262.7 million for the preceding quarter and the second quarter of 2016, respectively. The effective tax rate for the second quarter of 2017 was 19.0% compared with 19.0% and 8.6% for the preceding quarter and the second quarter of 2016, respectively. The year-over-year increase in the effective tax rate was mainly due to the fact that certain of our subsidiaries were recognized in Key Software Enterprises in the second quarter of 2016 and subject to a preferential tax rate of 10% for 2015, and we recognized related tax credits in the second quarter of 2016. The effective tax rate represents our estimates as to the tax obligations and benefits applicable to us in each quarter.

Net income attributable to the company's shareholders for the second quarter of 2017 was CNY 3.0 billion or USD 438.4 million. This compares with CNY 3.9 billion and CNY 2.7 billion for the preceding quarter and the second quarter of 2016, respectively.

Non-GAAP net income attributable to the company's shareholders for the second quarter of 2017 was CNY 3.5 billion or USD 512.2 million. This compares with CNY 4.3 billion and CNY 3.2 billion for the preceding quarter and the second quarter of 2016, respectively.

During the quarter, we had a net foreign exchange loss of CNY 131.3 million or USD 19.4 million. This compares with a net foreign exchange loss of CNY 48.5 million and a net foreign exchange gain of CNY 77.3 million for the preceding quarter and the second quarter of 2016, respectively. The year-over-year and quarter-over-quarter changes in foreign exchange gains and losses were mainly due to unrealized exchange gains and losses arising from our U.S. dollar-denominated bank deposits and short-term loan balances as exchange rates of the U.S. dollar against the Renminbi fluctuated over the period.

Our basic and diluted earnings per ADS were USD 3.33 and USD 3.31, respectively, for the second quarter of 2017. This compares with basic and diluted earnings per ADS of USD 4.40 and USD 4.36, respectively, for the preceding quarter and basic and diluted earnings per ADS of USD 3.06 and the USD 3.04, respectively, for the second quarter of 2016.

Our non-GAAP basic and diluted earnings per ADS were USD 3.89 and USD 3.86, respectively, for the second quarter of 2017. This compares with non-GAAP basic and diluted earnings per ADS of USD 4.86 and USD 4.82, respectively, in the preceding quarter and non-GAAP basic and diluted earnings per ADS of USD 3.62 and USD 3.60, respectively, for the second quarter of 2016.

As of June 30, 2017, our total cash and cash equivalents, current and noncurrent time deposits and short-term investments balance totaled CNY 41.2 billion or USD 6.1 billion compared with CNY 36.9 billion as of December 31, 2016. Cash flow generated from operating activities was CNY 2.3 billion or USD 342.4 million for the second quarter of 2017 compared to CNY 4.0 billion and CNY 3.3 billion for the preceding quarter and the second quarter of 2016, respectively.

As part of our commitment to return value to our shareholders, our Board of Directors approved a dividend of USD 0.83 per ADS for the second quarter of 2017, which is expected to be paid on September 1, 2017, to shareholders of record as of the close of business on August 25, 2017. Additionally, under our share repurchase program announced on November 15, 2016, we have repurchased approximately 366,000 ADS for approximately USD 100.3 million by the end of the second quarter 2017.

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

(Operator Instructions) We'll take our first question from Alicia Yap with Citi.

William and Charles. Congratulations to Charles on your new role. I have 2 questions. The first one is related to your sales and marketing expense line. So the expense grew quite a -- hello? Yes. Can you hear me?

Yes, yes.

Okay. Yes, so my first question is related to the sales and marketing expense. So because the line actually grew quite a bit on the sequential and year-over-year basis and, from your prepared remarks, seems to indicate that increased spending is more related to game promotions. So wanted to know, is that mainly related to overseas Onmyoji promotion? And I recall, in the past, management actually has a disciplined approach in spending the sales promotion and tend not to allocate, for example, more than 10% of specific games revenue on marketing. Has that target actually changed? And then, were you able to receive the effective promotional tractions with this step-up spending during the quarter? How should we think about the spend for the second half of this year? Then second question is, for your new games, can you share with us the expectations for the Forever 7 and Index? Will that be more similar to Onmyoji? And how should that be different versus other existing Japanese games in the market?

Okay. Let me translate the questions. The first question I will answer that, and then the second question, I will translate for the management to answer. So Alicia, the first question on the sales and marketing expense. Number one, the 10%, you mentioned the target. The target remains pretty much unchanged. For the second quarter of 2017, the sales and marketing expense increase is mainly a combination of continued spending on games as well as some of the sales and marketing-related promotion expenses on our e-commerce businesses, which are, again, largely in line with the management's budget and expectations. And going forward, we are going to be -- still remain disciplined by our target. And we do see that sales and marketing expenses will continue to grow on a dollar basis, but overall, that principle and discipline would remain unchanged. So for the second question, let me quickly translate for the management. (foreign language)

(foreign language)

Okay. So for these two games, they are Japanese-themed RPGs. Our expectations are that these will further broaden our game portfolio and target the ACG generations for these two mobile games. Yes, and these -- by the way, these two games, we are now targeting for launch by the end of this year.

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

Quickly on two things. We know that Minecraft has been just launched, so wondering if there is any user feedback and indications of the user engagement. And then, secondly, about the e-commerce business. We noticed that the gross margin's coming down because of, in the press release, about the mix shift in the e-commerce business. So wondering if you could clarify a little bit on what's the mix shift within the e-commerce business.

Okay, I will translate the first question, first. (foreign language)

(foreign language)

Okay. So for Minecraft, Eddie, for your first question. Minecraft, the preliminary feedback from the PC version is positive and within the management expectation, and we're happy to see that, and we continue to plan to launch the mobile version in Q3 of this year. Your second question is asking for the gross profit margin shift for the e-mail, e-commerce and other business segments, right, Eddie?

Yes, Charles.

Yes, the GP margin change is mainly a reflection of the product mix change. As you know that the contribution from Yanxuan and Kaola continue to increase in that segment. So naturally, it brings down the margin given the product -- the mix shift. Going forward, the management is contemplating for potentially more disclosure on the e-commerce so that analysts, audience and shareholders will gain more information on the performance of our e-commerce segment.

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

William, Charles and Juliet, I have two questions here. Firstly, I heard management mentioned in the prepared remarks, you are continuing to invest in VR and AR games going forward. So I just wonder if management can provide any color regarding how long you think it may take before we can see this AR/VR game market to take off. Secondly, about your e-commerce business. And based on my calculation, e-commerce revenue already represents 20% of our total revenue. So I just wonder, at such a scale, is it time for management to consider improving the profitability of your e-commerce business? Or you think it's still too early to consider profitability, and your focus remains on growing the market share at current stage? I will translate it into Chinese. (foreign language)

(foreign language)

So let me -- for the benefit of the audience, let me quickly translate the answers addressed by William. So first question on the AR/VR games. William commented that -- AR and VR are slightly different here in China. For VR, he thinks it takes at least another 2 years or so to be ready in China. Again, it's mainly restricted by the readiness of the equipment and hardwares. On that note, NetEase, we've actually started early, and we currently do have a VR game, Twilight Pioneers, that is distributed on the Google Daydream platform. For AR, we see more efforts being put into gameplays. We are yet to see a mature and successful AR game in the market. It's more of deploying AR as part of a gameplay. So we will be excited to see the development on the AR side. Second question on the e-commerce, the balance between growth and profitability. As you all know, we have Kaola, which is mainly focused on cross-border e-commerce, and Yanxuan that is our private label e-commerce platform. And at this stage, our focus is still mainly to grow the growth and market share. We want these two platforms and our services and products to cover more families and users. In China, we see a huge upside of consumers demanding for reliable high-quality goods and valuable goods. So profitability is not a near-term focus. Having said that, we will not undermine the profitability by doing subsidies in our other activities.

We'll take our next question from Chi Tsang with HSBC.

This is Wayne Wang speaking on behalf of Chi. So I have a question regarding Yanxuan. So I have noticed that Yanxuan recently opened a first hotel in Hangzhou. Does management have any expectation on this new hotel? And is this a kind of like strategic role provided by Yanxuan hotel? And will Yanxuan do more initiative in new hotel going forward? (foreign language)

(foreign language)

Okay. So for the question on the hotel. So first of all, William would like to clarify that, NetEase, we actually do not own or operate any hotels in Hangzhou. The news mentioned about a hotel that is a business collaboration between Yanxuan and Atour Hotel. And we -- again, we don't own or operate that hotel. We have 10 rooms and a lobby in that hotel that we decorate and design with the products from our Yanxuan platform. So we view this as more of an offline marketing promotion event, because we want to give the users or the guests of the hotel a firsthand experience and exposure to the Yanxuan products, and they can feel and they can see how the Yanxuan products can help lift up the experience of a home stay. So that's the intention of our collaboration with this Atour Hotel.

And we'll take our next question from Natalie Wu with China International Capital Corporation.

Will and Charles and Juliet, so two questions here. The first one is what's the licensed games revenue contribution this quarter? And what do you expect that will be listed on future license game pipeline that would possibly have an impact on the license game revenue contribution? And also, can you touch a little bit on the future overseas expansion plan? And the second question is that you -- for William, you mentioned that about the 5-year target for your Kaola e-commerce business earlier, like 2016 in some media reports, to grow Kaola's GMV to CNY 100 billion. So just wondering if the target still holds. (foreign language)

(foreign language)

So let me quickly translate William's comment. First, on the games. We -- obviously, we are continuing our efforts for the collaborative games, and the most anticipated title is Minecraft. And we have high expectations for Minecraft in the future. And for the overseas game expansion plan, again, NetEase puts in many efforts in actively exploring foreign titles, bring that into China, as well as good opportunities of internationalization of our own IPs. Second question on Kaola. So as you all know that the policies and regulations shifted a little bit in China last year, April 8, the policy on the tariff rate as well as some annual spending caps of individual consumers on cross-border e-commerce purchase. But having said that, we think cross-border e-commerce has huge potential -- growth potential going into the future. As you all know, a lot of Chinese tourists, when they travel abroad, their spending can reach [CNY 1.6 trillion] last year, and that's physical spending overseas. And that just represents a fraction of the cross-border e-commerce opportunity. And for Kaola, we're very happy and proud that it is now the #1 cross-border e-commerce platform in China, and we are in a leading position in terms of the GMVs and revenues generated on our Kaola platform.

We'll take our next question from Karen Chan with Jefferies.

William, Charles and Juliet, there are two questions here. First question is we saw some pretty good, encouraging performance coming out of Onmyoji launch recently in South Korea. Just wondering if management has a target on overseas revenue contribution from mobile games. And secondly, just want to get your thoughts on any M&A plan strategy in the mobile game business.

Okay, let me quickly translate the questions. (foreign language)

(foreign language)

So let me translate the first question (sic) [answer]. Onmyoji in Korea, we see great feedbacks, and it was ranked #7 in terms of growth in -- and #1 in terms of the number of downloads. We are happy about the results, and we will continue other internationalization plan for this game. (foreign language)

(foreign language)

For M&A, William's comment is that, again, NetEase, we are always very open-minded. We are actively exploring potential opportunities. But at this stage, we do not have anything that we would need to disclose or comment.

We'll take our next question from Han Joon Kim with Deutsche Bank.

Great. I have two as well. The first one is just your overall impressions as you continue to do overseas expansions. So you've launched a few games into the U.S., Onmyoji into Japan. You've had your trial with Kakao in Korea and so forth. What do you guys feel like you need to do more of or less of? I mean, it could be ranging from more R&D -- having more R&D overseas, it could be just having to do more marketing or so forth. Just kind of want to get your overall impressions, as I feel like this is still an evolutionary process. And then, the second question is just on the relative volatility that we're seeing for Westward Journey mobile relative to FWJ and Ghost, as far as the third quarter is concerned. So within the iOS ranking, it seems to be showing a little bit more volatility than the others. Do you think there's a particular reason for that? Or is it just kind of receptivity to the latest content update and just kind of more seasonal?

Okay. Let me translate these two questions for the management. (foreign language)

(foreign language)

So let me translate the answers. First question on the overseas overall plan strategies. So we currently have our R&D offices in Korea and in the states, and we will continue to invest into resources overseas. And in terms of our games, we prioritize the market that has -- that may have higher receptivity of our content and products. For the near term, we're focusing on Japan, Korea and Southeast Asia. In addition, we are also developing games and contents that are more tailored for North American and European markets. For instance, Crusader of Light, the U.S. version of Land of Glory, was successfully launched into the U.S. market. On your second question on the volatility around Westward Journey. So as you know, Westward Journey and Fantasy Westward both are MMORPG games. They've been up and running for over a decade, and it was actually very, very encouraging to see that legacy titles like these with such a long operating history are still growing. And the short-term volatility performance, that's very well within the management's operational expectation.

We'll take our next question from Angela Xu with UBS.

I have two questions. So one is on the e-commerce margin -- a follow-up question on the e-commerce margin. So other than the product mix shift, so how is the margin trend in Kaola and Yanxuan, respectively, over the past quarters, and also, the change? And also, when can we expect Kaola to break even? And the second one is on the international expansion. So I'm just wondering, how is the market profile of international business compared to domestic business?

Sorry, just to clarify your second question. Your second question is asking for international expansion for games for the...

Yes. Yes, yes, yes. It's for games. Yes, correct.

For games, okay. Let me answer the first question first, and then I will translate the second question for the management. For Yanxuan and Kaola, the margins are relatively stable. And as we continue to grow our scale, we do see the skill factor will benefit us. And on your part -- the breakeven point for Kaola, as Mr. William Ding mentioned previously, our near-term focus is still mainly to grow the market share and the user base growth. And the margin or breakeven profitability is not our near-term focus, and that will naturally come as we reach a critical mass in terms of scale. And the second question, I will translate. (foreign language)

(foreign language)

So for your second question in terms of the margin impact from our overseas games. So it really depends on the type of how we distribute our games overseas. Just for instance, in Korea, when Onmyoji's distribution is through local partnership with a Korean distributor, then in -- under this mode, this will not affect our margins, generally speaking. But in other countries, for instance, Japan, when we launched Onmyoji and it was operated by ourselves, and we do see some impact in terms of overall margins because we need to spend on the marketing and promotion efforts, as well as the user acquisition profile in overseas market might be different from the Chinese market, again, depending on the target market.

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

Thanks again, everyone, for joining us. If you have any further questions, feel free to contact Juliet Yang, NetEase's Senior IR Manager in Hangzhou, or The Piacente Group Investor Relations. Have a great day.

This does conclude today's conference. We appreciate your participation.