NetEase, Inc. (NTES) Q2 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, thank you for standing by. Welcome to the NetEase Second Quarter 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, the 15th of August, 2013. I would now like to turn the conference over to Brandi Piacente. Please go ahead.

Thank you, operator. Please note the discussions 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. As a reminder, this conference is being recorded. In addition, a webcast replay of this conference call will be available on the NetEase corporate website at ir.netease.com. I will now turn the conference over to Mr. Onward Choi, acting Chief Financial Officer, who will read the prepared remarks on behalf of Mr. William Ding, Chief Executive Officer of NetEase.

Thank you, Brandi. Before I begin, please note that for the purposes of this discussions, all percentages are based on Renminbi. We made exciting progress in the second quarter to expand and diversify our portfolio of internet games, products and services. Through the introductions of new games, applications and online services, as well as enhancements to our existing offerings, we are reaching a growing community of traditional online and mobile users. Our strong results for the quarter were driven once again by our popular self-developed games and advertising services. Our total revenues increased by 20.4% year-over-year, and 6.9% sequentially to RMB 2.4 billion. Led by a number of advancements with our self-developed games, including new game launches, expansion packs and upgrades to attract current and new users, revenues from our online games segment increased by 18.2% year-over-year. This year, we have already introduced several new games that diversify and expand our portfolio. Most recently, in April, we introduced our 3D realtime strategy game, Heroes of Three Kingdoms. We plan to launch a major marketing campaign for this game in the third quarter. We are very excited about this game and believe this is an opportunity for Heroes of Three Kingdoms to set a new benchmark for success among China's realtime strategy games market. In August, we also launched our next-generation 3D MMORPG, Dragon Sword. We look forward to growing Dragon Sword's user base and introducing players to this thrilling gaming experience. We are also excited to have introduced 2 comprehensive upgrades of the popular predecessor games Ghost II in April, followed by Fantasy Westward Journey II in July. These compelling new additions are already demonstrating early success as goes to reach record high PCUs in April and achieve record revenue for the quarter. With Fantasy Westward Journey II, we are pleased to announce that we introduced an accompanying mobile versions, along with these thrilling updated game versions. Now our users can enjoy one of our most popular and longest running games on both their PCs and mobile devices. The trend in mobile games is progressing, and our extensive R&D capabilities make NetEase well-positioned to broaden our user base by introducing new mobile games as well as mobile versions of some of our most popular self-developed titles. In line with this strategy, we plan to introduce several mobile games in the coming months. We see mobile games as an excellent opportunities to complement our traditional online games and are excited to provide this new offering to our exciting and new users. In addition to our mobile and new game introductions, during the second quarter, we released expansion packs for Tianxia III, Westward Journey Online II and Westward Journey Online III. Fantasy Westward Journey and Westward Journey Online III deliver solid performances following the price adjustment that were implemented in February for these games, as well as the launch of an item-based versions of Westward Journey Online III in May. During the same quarter, the performance of Westward Journey Online II also remained steady, and Kung Fu Master delivered an excellent performance supported by a major marketing campaign that we initiated at the end of March. In the third quarter, we plan to introduce new game titles and contents. These initiatives are well underway, as we have already released new expansion packs for Legend of Fairy and New Fly for Fun in mid-July. Expansion packs for Westward Journey Online II and Westward Journey Online III are both coming this quarter. We are currently targeting September for these releases, and we expect the expansion pack for Westward Journey Online II to be one of the most important upgrades for this game since the initial launch of this popular title. We are also making good progress on our new game development assets. We are currently on track to introduce our 2.5D MMORPG Legend of Tibet later this year, followed by a first-person shooter game, which will mark our first game in this genre. Turning to our advertising services. Revenues for this segment also performed well, led by automobile, Internet services and fast-moving consumer goods sectors. For the quarter, our advertising services grew by 64.5% sequentially due to the season increase in advertising spending in the second quarter, and 33.3% year-over-year. Our comprehensive web portal services also grew during the same quarter as we continue to improve product integrations and marketing services innovations for our traditional and mobile Internet offerings. As of June 30, 2013, we have over 570 million email users, and the number of enterprise email users continues to grow at a healthy pace. Looking at our mobile applications, we continue to reach a broad audience and view up our volume [ph] of popular applications. At the end of June, our leading mobile news applications reached 120 million installations and 40 million daily active users. I'm also pleased to announce that during the second quarter, we secured an exclusive strategic cooperations with Air China to offer our newest applications, with in-flight's Wi-Fi service to reach an even greater audience. Our new applications are also resonating well with users. For example, our NetEase Cloud Music application, which we've released in late April, has been well-received by users. Momentum for Youdao Cloudnote has also been strong, reaching 50 million users at the end of the quarter. And Youdao Dictionary now has 350 million cumulative users, of which 180 million are from mobile devices. This growth was supported by the mobile versions we released in May, which continues to stimulate the number of daily active users for Youdao Dictionary. Our wide community is growing, and we are reaching more and more users with our extensive portfolio of online products and services. Our momentum is strong and we will continue to extend these offerings to Chinese audiences, while also exploring international opportunities to bring our content-rich games overseas. At the same time, we remain focused on growing our robust game portfolio and service offering for traditional online and mobile users by bringing our loyal community compelling content across our growing business. This concludes William's updates. Now, I will provide a review of our 2013 second quarter financial results. I will primarily focus on the discussions of margins and expense fluctuations, along with net profits. Total sales tax for the second quarter of 2013 were RMB 149.3 million or USD 24.3 million. Compared to RMB 105.4 million and RMB 41.8 million, for the preceding quarter, and the second quarter of 2012 prospectively. The increase in sales tax was mainly due to a change in the tax rules in China, which resulted in our online game revenues becoming subject to value-added tax instead of business tax, with the full quarter effect beginning in the second quarter of 2013. The increase in value-added tax was substantially offset by reductions in business tax on intra-group revenues, which were previously recorded in our cost of revenues. This change in the tax rules in China did not have a significant impact on gross profit of our online game services business segments. As a result, the increase in gross profit margin was attributable to the lower net revenue due to the increased value-added tax in sales tax. Gross profit for the second quarter of 2013 was RMB 1.7 billion or USD 276.6 million compared to RMB 1.5 billion and RMB 1.3 billion for the preceding quarter and the second quarter of 2012, respectively. The increase in gross profit was primarily attributable to an increase in gross profit from advertising and online games businesses, which was partially offset by the gross loss from our email, Wireless and Value-Added Services and Others business segments. The quarter-over-quarter and year-over-year increases in online game revenues were primarily driven by increased revenues from our self-developed games, Fantasy Westward Journey, Kung Fu Master, Ghost II and Westward Journey Online III, which were partially offset by a decline in revenue from World of Warcraft, a game license from Blizzard Entertainment. The increase in advertising services revenues was primarily due to the rise in demand for advertising services, mainly from the automobile, Internet services and fast-moving consumer goods sectors. Gross profit margins for the online game business for the second quarter of 2013 was 80.9% compared to 77.8% and 73.3% for the preceding quarter, and the second quarter of 2012 respectively. The increase in gross profit margin was mainly due to the changes in tax rules, which I previously mentioned. Gross profit margin for the Advertising business for the second quarter of 2013 was 55.5% compared to 29% and 33% for the preceding quarter and the second quarter of 2012 respectively. The increase in gross profit margin was primarily due to economies of scale, as our advertising revenue increased in the second quarter without a corresponding increase in advertising-related costs. Gross loss margins for the email, Wireless Value-Added Services and others business for the second quarter of 2013 was 21% compared to 13.1% and 11.6% for the preceding quarter and the second quarter of 2012, respectively. The increase in gross loss margins was mainly due to increased operating costs related to our mobile applications, such as NetEase Cloud Music and EaseRead. Total operating expenses for the second quarter of 2013 were RMB 626 million, or USD 102 million compared to RMB 455.6 million and RMB 437.7 million for the preceding quarter and the second quarter of 2012, respectively. The increase in operating expenses was mainly due to increased salary and marketing promotional activities in the second quarter of 2013, mainly resulting from promotional activities that were conducted for Ghost II, Blizzard Entertainment's World of Warcraft, Heroes of Tang Dynasty II, Kung Fu Master, and NetEase's portal business, as well as increased research and development costs for our game pipeline. We recorded a net income tax charge of RMB 131.8 million or USD 21.5 million for the second quarter of 2013 compared with RMB 142.9 million and RMB 149.5 million for the preceding quarter and the second quarter of 2012 respectively. The effective tax rate for the second quarter of 2013 was 10.8% compared to 11.8% and 14.8% for the preceding quarter and the second quarter of 2012, respectively. During the second quarter of 2013, we recognized RMB 47.1 million in tax credits related to certain incentives for a deduction in research and development expenses, agreed on by tax authorities during the annual tax filing of our PRC entities. The company's various principal subsidiaries renewed their qualifications as High and New Technology Enterprises in 2011, and enjoyed the preferential enterprise income tax rate of 15% from 2011 to 2013, subject to annual review by the relevant tax authorities in China. During the second quarter of 2013, we've reported a net foreign exchange gain of RMB 5.6 million or USD 0.9 million compared to a net foreign exchange loss of RMB 9.3 million and RMB 36 million for the preceding quarter and the second quarter of 2012, respectively. The quarter-over-quarter and year-over-year changes in foreign exchange gains and losses were mainly due to the unrealized exchange gains and losses arising from the -- from our foreign exchange -- foreign currency denominated bank deposit and short-term loan balances as of June 30, 2013, as the exchange rate of the euro and U.S. dollars against the RMB fluctuated over the period. Net profit for the second quarter of 2013 totaled RMB 1.1 billion, or USD 178.4 million compared to RMB 1.1 billion and RMB 875.3 million for the preceding quarter and the second quarters of 2012, respectively. We reported basic and diluted earnings per ADS of USD 1.37 each for the second quarter of 2013. The company reported basic and diluted earnings per ADS of USD 1.34 and USD 1.33, respectively, for the preceding quarter, and reported basic and diluted earnings per ADS of USD 1.09 and USD 1.08, respectively for the second quarter of 2012. As of June 30, 2013, our total cash, time deposits and short-term investments were RMB 17.4 billion or USD 2.8 billion compared to RMB 16.3 billion, as of December 31, 2012. Cash flow generated from operating activities was RMB 1 billion or USD 171.1 million for the second quarter of 2013 compared to RMB 1.5 billion and RMB 880.9 million for the preceding quarter and the second quarter of 2012 respectively. Thank you for your attention. We would now like to open the call to your questions. Operator, please go ahead.

[Operator Instructions] And the next question comes from Dick Wei from Credit Suisse.

I have 2 questions. First one is on the new game Crisis 2015, wondering what is the latest situation and what kind of market share can the game get within the first-person shooter segment? And the second question is on the mobile game development. I wonder if management can discuss some of the new pipeline within the mobile game space? [Chinese]

[Chinese]

Okay, so basically, for the first question regarding our FPS game, basically what we expected is by the end of this year, we will launch the closed beta testing for this game, and we also got high expectations on this game and believe that with the launch of this new game genres to the China market, we would be getting certain market share in this segments. And for the second question regarding the mobile game developments and pipelines, basically, the whole R&D team are currently working smoothly. Basically, the whole progress are well underway and following our milestones and our expectations.

And the next question comes from Alicia Yap from Barclays.

My first question is regarding your online advertising revenue. So you achieved a [indiscernible] very strong growth this quarter. So can you share reverse of -- is there any percentage after at revenues currently come from mobile devices?

[Chinese]

[Chinese] So basically, with regard to the proportions of our advertising revenues coming from our mobile fronts, I think basically at this stage, at this point of time, the portion would still be relatively small, but on the other hand, I think that we will put more emphasis on the experiences, the user experiences of our users using their mobile devices. And for now, products like our mobile news applications or our Youdao Dictionary and other similar applications, although they are building up their tractions and also we've got a very good popularity there, but at the moment, we do not set aside too much areas for placings the ad stairs. [ph] But we do host a positive route going forward to this.

Second question I have is, I wanted to get some color in terms of the performance or the traction on some of your new games. So how would you rank or compare the initial results or the user interest in like the Heroes of Three Kingdoms and Dragon Sword to your other new games, like Tianxia, Ghost, or Kung Fu Master? And among all these successful new games, is there any one of them actually stand out to be more like a blockbuster hit?

[Chinese]

[Chinese]

So basically, with regard to the examples that Alicia has brought up just now for Heroes of Three Kingdoms, basically, this would be a DotA kind of games or the new sport kind of games. And so in terms of the game genres, it can not be compared directly with our other games like the Tianxia II or III, or even the Kung Fu Master. But and we also will that for Heroes of Three Kingdoms by the game itself. It would be focusing to a special group of players who would go for the new sport or DotA kind of gaming experiences. And so far, we believe that the competitions in this part of the market is intense. That's a fear. But we do believe that with the good qualities of games that we develop and launch so far, we would be able to set up a new benchmark in this special part of the market segment. And on the other hand, going forward, we will be rolling out another new game, which is called the Dragon Sword, which is a 3D MMORPG game, and we also term it as a next-generation 3D MMORPG game with a special focus on action type of game. And we do look forward that the role of this game was targeted to a special spending group or a special group of players who are looking for different kind of gaming experiences. And having said that, by far, we still can't tell how much or how successful those games will be contributing in terms of revenues. But we do believe that as we follow our philosophy so far in our games development, targeting towards good quality and good user experiences, we will be able to excel in this part of the market. Thank you.

And the next question comes from Timothy Chan from Morgan Stanley.

My question would be also on the mobile game. I understand that you have just launched the mobile version for Fantasy Westward Journey. I wonder if you would be able to talk about the reception so far. Are you attracting new gamers to this mobile game? Or whether you're just being some PC gamers migrating to your mobile version of this game? And separately, I think the recent focus in the China Internet space is for the -- I mean the basing [ph] strong mobile game platform performance recently. Would you be able to comment on that as well?

[Chinese]

[Chinese]

So far, we have a satisfactory responses by launching the new mobile versions of the Fantasy Westward Journey II in the market. And on the other hand, we do see that the role of this game is that -- would be complementary to what we are currently working on both the PC end and also the mobile end. And we believe that those 2 will be supplement to one another.

[Chinese]

Okay. So basically, we also -- we were quite positively that the ratings has also impacted the game centers on its racing platforms and basically, this will be just following what the Korean counterparts has been doing so far.

And the next question comes from Eddie Leung from Merrill Lynch.

I have 2 questions. The first one is about the PC online gaming market. From your observation, is the overall PC online game market user base still growing? And if not, how NetEase can take market share from the competitors? And then my second question is related to your sales and marketing expenses. There were some fluctuation in the sales and marketing expenses in the second quarter. So wondering if there would be any indication for the near-term spending in sales and marketing?

[Chinese]

[Chinese]

So basically, our will [ph] on the PC online game market is that in China, basically, the Internet market is very vague and very latched, [ph] and we still believe that there are immense room for launching different kinds of products and services, as long as they are of good qualities and can meet or surpass the expectations of our users or the players alike. And in general, we still believe that for NetEase, we do got the growth potentials in this area. And because not only that on the PC front, but also on the mobile front, and we believe that with the launch of more new products and services in the market that can better diversify ourself in this segment, we would be able to prove that we do got a very good ground for further growth in the upcoming futures. And so -- [Chinese] -- so Eddie, regarding your second question about the S&M spending in Q2, you are quite right in saying that the amount has been quite large as compared with the first quarter, but this is mainly due to the fact that there would be quite some new game titles that we have launched during the quarter where we have put in more efforts to do the marketing and promotions, like the Heroes of Three Kingdoms, the World of Warcraft, Heroes of Tang Dynasty II and other game titles like that. But still, we do believe that going forward for this year, on an annualized basis, we do still target to upkeep our current expectations that the total S&M spending for the whole year would be somewhere around 10% out of our total net revenues. And we do see that in different quarters would be the peak seasons [ph] over the year, where we would also put in more efforts in promoting our other games.

And the next question comes from Jialong Shi from CLSA.

I have 2 questions. First question is about mobile, about your mobile games. Management mentioned NetEase has -- you guys have few mobile games in the future, in the pipeline. Can you quantify how many mobile games you plan to launch this year and what are their role is. And for mobile games, it seems that most of the existing blockbuster titles are developed by small studios, so just wondering what are the ages of PC game developers like NetEase in mobile? [Chinese]

[Chinese] So basically, with regard to the exact numbers of mobile games that we are going to roll out in the upcoming periods, first of all, for now, we do not got any specific numbers to talk about yet, but we do definitely will rollout our new games in a progressive manner. And in regard to how the big online game companies like NetEase could excel in this part of the market, basically, we have accumulated quite a lot of experiences in the markets of developing successful games so far, and for each game title that we are going to develop or to roll out, before we actually do anything, we would first have to think seriously on how well we could succeed in the market, or -- before we actually go ahead on the development process. Say for example on the type of games that we are going to roll out and how -- what will be the features and the special things that we would like to add in before the development cycles. And we also got a very strong team of planning people to gather different ideas and to facilitate the whole development process. And as such, we believe that we do got a good competitive edge in this area in expanding our footprints in the mobile games area.

My second question is that, according to media report, your competitor, Tencent, recently acquired certain stake in Activision Blizzard. So just wondering if that would have any impact on your current partnership with Blizzard. And also, NetEase has been very much focused on in-house developed games in the past. Your few licensed games are all from Blizzard, while some of your competitors have a more diversified license in-sources. So just wonder, if NetEase might also consider licensing games from other developers, such as Korean developers in the future. With the other one, can you just -- [Chinese].

[Chinese] So basically, with regard to your first question on the potential impact on business, Tencent stake on ATVI, basically, we did not see there would be any significant impact as such because we do maintain a very strong relationship with the Blizzard side. And at the same time, we both share the same visions to serve the market in China. And one more point to supplement on William's remarks is that, if you take note on our latest or the recent announcements that have been made regarding our latest cooperation with the Blizzard side, we have entered into an agreement to license another new free-to-play strategy card games for PC and iPad called Hearthstone: Heroes of Warcraft. And again, this would prove that we have further and deepens our relationship with the business, other than the existing license game titles like the World of Warcraft or the StarCraft II, which is very encouraging. On the other hand, with regard to your questions about our potential or the possibilities of licensing games from overseas, basically, we would -- we will positively, because we do see that there would be -- whenever there would be any good titles that can fit in our criteria in terms of the game channels or the game play, the features, as in terms of the qualities and also, how well they could fill in the user experiences as such, we are quite open to license game, as such, no matter it is from overseas or in China.

May I have a quick follow-up? How much of your game revenue came from Warcraft in 2Q? [Chinese]

[Chinese] The market shares of -- the contributions of World of Warcraft to our overall online game revenue will be less than 15%.

And the next question comes from Alex Yao from JPMorgan. Alex Yao - JP Morgan Chase & Co, Research Division: I have 2 questions. Number one is on the gaming revenue growth, you guys delivered a very robust 18% year-over-year growth. Would you be able to share with us to what extent the gaming revenue growth is driven by usage growth? And to what extent is the ARPU -- ARPU growth? And my second question is a followup to one of the previous questions. From the company's perspective, are you seeing total number of active users and total time spent on your platform growing or remain flattish or declining over the past 4 quarters? [Chinese]

[Chinese]

[Chinese] So basically, for the first question about the game revenue growth, basically because by now, the -- we have quite a wide array of game portfolios that possess different kind of features, and so basically, we do not specifically divide it, how much of them would be contributors from usage or from the ARPUs, but definitely, we focus more on the experiences on the money that they are going to spend and making sure that they could get the values that they are expecting in order to keep them with us to enjoy the entertainment within our games. And for the second question, basically, for the total active paying users, so far from our observations, this has been growing in the past 4 quarters.

Next question comes from Tian Hou from T.H. Capital.

I have a question related to your mobile game. And as you guys started to put up more and more mobile game, so what is a mobile game distribution channel? So are you going to use your mobile apps, such as your news -- such as your mobile dictionary? And also, mobile game, what is the margin outlook for mobile game? And my understanding is a lot of developers of mobile game, they have to spend significant amount of money on the channel distribution. So what is NetEase's outlook in that front? [Chinese]

[Chinese] So basically, with regard to -- on the potential cost of distributing to mobile games, our worry is that potentially this might be lesser as compared with the traditional PC front. First of all, because the size of each client-based applications will be much smaller than what we are experiencing on the PC front. And as such, the user or the players would use less time to download the new applications. And at the same time, we also expect that for the mobile games, the server consumptions would also be lesser as with the traditional PC front. And we do believe that with the introductions of the mobile games to the market, we can better take into this part of the market by utilizing the fragmented times that the people might have. And on the other hand, in terms of the potential market outlook,, because there would be various factors that we need to take into account. And just now, we may talk about that, and maybe they will be using a little bit less of actually the server or the downtimes would be lesser. This would be a positive factors. On the other hand, we do also need to take into account the potential other costs. And one more thing to supplement is that on distributing the mobile games, definitely, we have already got some popular mobile applications like the news and also the dictionary, and those will be the good places for us to distribute our various mobile game titles as well.

And the next question comes from Mark Marostica from Piper Jaffray. Sorry, there is no response, so I'll move to the next question. And that comes from Jiong Shao from Macquarie.

This is George calling on behalf of Jiong. I have 2 questions, the first one is regarding your mobile games. We see that you have this mobile or pocket version of Fantasy Westward Journey already online, but I think it's more -- like, as you said, it's more supplementary, it's more like a plug-in for the PC version of the original game. So I just wonder, because some of your competitors already put out some full version of MMORPG games on the mobile side. So what's your thought on this, and are you going to launch also this mobile -- a long version, or a cross-platform version of bigger games going forward? And how are you going to assure the fairness between different platforms? And -- [Chinese].

[Chinese]

[Chinese] So basically, for the first part of your first question, basically, we do believe that the introduction of the pocket versions of the Fantasy Westward Journey II would be quite an innovations for NetEase in the sense that we can extend the gaming experiences of the players from PC to the mobile phones. And at the moment, we do see that this will be quite a good expansion and the presence of these 2 platforms will be complementary to one another. And regarding the second part about the potential cross platform or the potential fairness issues. Basically, we do worry [ph] that the gaming experiences of users on the PC front and the mobile front would be quite different. And we do not see that there would be an immediate needs to pool the 2 group of people together on one service to play or to compete. And we do see that by having 2 platforms, one on the PC front and the other one on the mobile front, would be a more good things for the people to experience the happiness of playing the games itself.

Thank you, ladies and gentlemen. We'll now hand back the conference call to management and closing remarks. Thank you.

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

Ladies and gentlemen, this concludes the NetEase Second Quarter 2013 Earnings Conference Call. This conference will be available for replay after 11:00 a.m. today, 3:00 till midnight, 29th of August, 2013. You may access the replay system at any time by dialing U.S. local plus 1 (303) 590-3030, U.S. toll-free 1 (800) 406-7325 and entering the access code. Thank you for your participation. You may now disconnect.