NetEase, Inc. (NTES) Q3 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the NetEase Third Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. And at this time, I'd like to turn the conference over to Brandi Piacente, Investor Relations. 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 Litigations Reform Act. Such statements are not guarantees of future performance and are subject to certain risk 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, and 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.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 these discussions, all percentages are based on renminbi. Throughout the third quarter, we made a number of advancements that broaden our Internet games and service offerings. In additions to introducing new games and upgrades to our classic games, we increased our investment in our mobile capabilities. We see a considerable opportunities to connect with our growing community through further diversifications and mobile initiatives that supports our growth. For the third quarter, we increased our revenues by 23% year-over-year, with revenues from our online games, increasing by 21% and revenues from our advertising services growing 22.9%. During the third quarter, we completed important upgrades for 2 of our longest operating games. In July, we launched Fantasy Westward Journey II, along with the accompanying pocket mobile versions. This game delivered a fantastic performance and contributed to the increase in our online games revenues for the third quarter. In September, we introduced new Westward Journey Online II, and we are very pleased with the receptions to the new versions of this classic game, which has inspired additional enthusiasm for the game and positive user trends. Looking at some of our new games, Heroes of Tang Dynasty II has performed well since the launch of this most recent expansion pack in June and contributed to the growth of our online game business for the period. User feedback has also been encouraging, following our initial commercial launch of Heroes of Three Kingdoms in April and Dragon Sword in August, supported by the large-scale promotional activities that were initiated for those 2 games in September and November, respectively. In the coming months, we expect to see heightened interest for other newer game titles as well, such as Ghost II and Kung Fu Master, as we introduced expansion packs for these games in September and October, respectively. Turning to our portal, our advertising services revenues increased both sequentially and year-over-year, led by increased contributions from the automobile, Internet services and fast-moving consumer goods sectors. Our investment in mobile applications have attracted members to our active community, providing a delivery vehicle for our value-added services and advertisements. One of our most exciting additions to this mobile platform was our launch of YiChat in August, which marked our entry into the mobile instant messaging space. We were extremely pleased to partner with China Telecom to introduce this important application. YiChat diversifies our mobile portfolio and focuses on providing users with differentiated functionalities and a superior user experience. The Chinese population has quickly embraced YiChat, with downloads exceeding 1 million on the first day of its launch. By the end of October, we have more than 30 million registered users for YiChat, and these numbers continue to rise. YiChat significantly advises our mobile Internet strategy, and we continue to grow our loyal user base across our distinctive traditional and mobile portals. Our other industry-leading applications and email services also continue to attract new users. During the third quarter, we integrated a number of product updates, including new audio and video capabilities for our email. And as of September 30, 2013, we have over 590 million email users and 160 million installations of our leading Mobile News applications. As we are near the end of 2013, we have a number of initiatives underway. Earlier this month, we commercially launched Legends of Tibet, a 2.5D MMORPG, and before the end of the year, we plan to introduce new expansion packs for Heroes of Tang Dynasty II, Tianxia III and Legends of Fairy, as well as several high-quality mobile games. The upcoming open beta test in mainland China of Blizzard Entertainment's highly anticipated Hearthstone: Heroes of Warcraft, will become another important milestone. This new free-to-play online collectible card game is highly engaging and simple to play. We look forward to providing our players with this great gaming experience. Our development schedules for 2014 is also progressing smoothly. We are on track to release our first person shooter game, Crisis 2015, in the first half of the year. In addition, we are preparing to launch a game that has been under development for the past 3 years, and we expect to begin testing this game in the coming months. This will be a 3D epic fantasy MMORPG called Revelations. Revelations features exceptional computer-generated graphic app effects, using cutting-edge technology that integrates traditional MMO styles with enhanced action elements to provide young players with a cool and fast-paced fighting experience. We are growing our online and mobile users based on the continued popularities of our portfolio of games and online services, as well as our promising pipeline. To expand our reach even further, we have considerably diversified our mobile applications portfolio. As mobile devices become an increasing part of society, we are taking steps to create differentiated and compelling games, products and services that speak to this new audience. At the same time, we will continue to broaden our existing platform of powerful online and mobile Internet content. This concludes William's updates. Now I will provide a review of our 2013 third quarter financial results. I will primarily focus on the discussions of margins and expense fluctuations, along with net profit. Total sales tax for the third quarters of 2013 were RMB 157.7 million or USD 25.8 million compared to RMB 149.3 million and RMB 42.9 million for the preceding quarter and the third quarters of 2012, respectively. The year-over-year increase in sales tax was mainly due to a change in the tax rules in China, which resulted in our online game revenues gradually becoming subject to value-added tax, instead of business tax since 2013. This change in the tax rules in China did not have a significant impact on gross profit from our online game services business segment, as the increase in value-added tax was substantially offset by a reduction in business taxes on intra-group revenues, which were previously recorded in cost of revenues. As a result, the year-over-year increase in gross profit margin was primarily attributable to lower net revenue due to the increased value-added tax in sales tax. Gross profit for the third quarter of 2013 was RMB 1.7 billion or USD 285.4 million compared to RMB 1.7 billion and RMB 1.4 billion for the preceding quarter and the third quarters of 2012, respectively. The year-over-year increase in gross profit was primarily attributable to an increase in gross profit from our online game and advertising businesses. The year-over-year increase in online game revenues was primarily driven by increased revenues from our self-developed games, primarily Fantasy Westward Journey II, Kung Fu Master, Heroes of Tang Dynasty II and New Westward Journey Online II, which was partially offset by a decline in revenue from World of Warcraft, a game licensed from Blizzard Entertainment. The year-over-year increase in advertising services revenues was primarily due to a rise in demand, mainly from sectors such as automobile, Internet services and real estate. The quarter-over-quarter increase in gross profit was primarily attributable to increased gross profit from our advertising services due to the reason previously mentioned and increased revenue from the one-off sales of certain game accessories, such as a limited-edition pack of our new Westward Journey Online II, which is included in the email by WVAS and others business. Gross profit margin for the online game business for the third quarter of 2013 was 79.7% compared to 80.9% and 74.2% for the preceding quarter and the third quarters of 2012, respectively. The year-over-year increase in gross profit margin was mainly due to the changes in tax rules that I previously mentioned. Gross profit margins for the advertising business for the third quarter of 2013 was 59.4% compared to 55.5% and 36.2% for the preceding quarter and the first quarter of 2012, respectively. The increase in gross profit margin reflects our abilities to effectively scale our advertising business. Gross profit margins for the email, WVAS and others business for the third quarter of 2013 was 4.1% compared to gross loss margins of 21% and gross profit margins of 6% for the preceding quarter and the third quarter of 2012, respectively. The increase in gross profit margin was mainly due to increased revenue contributions from sales of higher margins game accessories. Total operating expenses for the third quarter of 2013 were RMB 635.2 million or USD 103.8 million compared to RMB 626 million and RMB 537.5 million for the preceding quarter and the third quarter of 2012 respectively. The year-over-year increase in operating expenses was mainly due to increased staff-related cost, resulting from an increase in the number of employees and average compensation, as well as higher research and development investments. The quarter-over-quarter increase in operating expenses was mainly due to increased general and administrative expenses, and research and development expenses, which were partially offset by decreased selling and marketing expenditures for licensed game in this quarter. We recorded a net income tax charge of RMB 206.5 million or USD 33.7 million for the third quarter of 2013 compared to RMB 131.8 million and RMB 194.8 million for the preceding quarter and the third quarter of 2012 respectively. The effective tax rate for the third quarter of 2013 was 16.5% compared to 10.8% and 19.9% for the preceding quarter and the third quarter of 2012, respectively. During the second quarter of 2013, we recognized RMB 47.1 million in tax credits related to certain incentives for deductions in research and development expenses agreed on by tax authorities during the annual tax filing of our PRC entities. The year-over-year decrease in effective tax rate was due to the occurrence of a onetime accrued withholding tax of RMB 40 million associated with the offshore remittance of cash from China in connections with the declarations of the special cash dividends in the third quarter of 2012. Our 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 test authorities in China. During the third quarter of 2013, we've reported a net foreign exchange gain of RMB 5.9 million or USD 1 million compared to RMB 5.6 million and RMB 23.7 million for the preceding quarter and the third quarter of 2012, respectively. The quarter-over-quarter and year-over-year changes in foreign exchange gains were mainly due to the unrealized exchange gains arising from the company's foreign currency denominated bank deposit and short-term loan balances as of September 30, 2013, as the exchange rate of the U.S. dollars against the RMB fluctuated over the period. Net profit for the third quarter of 2013 totaled RMB 1 billion or USD 171.3 million compared to RMB 1.1 billion and RMB 811.9 million for the preceding quarter and the third quarter of 2012, respectively. We reported basic and diluted earnings per ADS of USD 1.32 and USD 1.31, respectively, for the third quarter of 2013. Our basic and diluted earnings per ADS were USD 1.38 and USD 1.37, respectively, for the preceding quarter, and we reported basic and diluted earnings per ADS of USD 1.01 each for the third quarter of 2012. As of September 30, 2013, our total cash, time deposits and short-term investments were RMB 18.2 billion or USD 3 billion compared to RMB 16.3 billion as of December 31, 2012. Cash flow generated from operating activities was RMB 1 billion or USD 165.9 million for the third quarter of 2013 compared to RMB 1 billion and RMB 670.1 million for the preceding quarter and the third 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] Our first question is from the line of Dick Wei with Crédit Suisse. Dick Wei - Crédit Suisse AG, Research Division: I have 2 questions. First question is about international expansion. I think NetEase may be participating at G-Star now, and then as well as having like a -- take an investment company in Korea. Maybe can the management comment a bit about the opportunities and the type of games it's going to bring to overseas. Secondly is about Yixin YiChat, when -- what is the financial impact that it be on the sales marketing line or on the balance sheet front from the Yixin investment? William, [Chinese]

[Chinese]

So regarding to William's press remarks on our international expansions, first of all, we'd like to highlight that NetEase has got a very superior team of R&D people who are able to produce some good qualities and high-quality products to the market. And by far, that's come to a more appropriate timing for us to consider and to move forward for certain of our game titles to the overseas market, and not just Korea alone, but we would also be open to consider the expansions to other areas as well. And the whole plan of doing the international expansion would start from the fourth quarter of this year. We will see more of these actions going forward. And so with regard onto your second questions, regarding the financial impact of the YiChat on the financials, I think the major changes will be that we have do an investment in the joint ventures of around RMB 200 million, and this has been reflected in our balance sheet as a part of our other long-term assets. And because we only got a 27 equities stake in the company, and so we would be taking the -- using the equity markets to account for it. And by far, the whole operations of YiChat is still in its early stage, and so we do not believe that it has a very significant impact to our income statement so far. Dick Wei - Crédit Suisse AG, Research Division: Great. And can I just have a quick follow-up on the international side. What kind of genre of games do you think we have more advantage going overseas? William, [Chinese].

[Chinese]

So basically because different country, we've got different kind of preferences on different products. And so far, I think we would not specifically pinpoint to which type of games that we will be doing in such kinds of overseas expansions in a particular country. But basically we will be taking into account on what we are currently offering, that would be a good opportunity to do the overseas expansions.

Our next question is from the line of Alicia Yap with Barclays.

I have a couple of questions. Number one is that, I was hoping that management can share with us some of the upcoming plans for this YiChat platform and how NetEase would benefit from this YiChat?

[Chinese]

Basically, we do see that the mobile handsets will be a -- for doing the instant messages or communications would be a very good entry point of moving to the mobile area, and we would also take the opportunities of going into this area by enhancing the user experiences and the recognitions of our services by our YiChat users. And for NetEase, we are always focusing on the China market, and this also reflected by the fact that we have been partnering with China Telecom in offering the YiChat services to the users in China in general. And with the rollout of the newer versions of the YiChat applications, we do look forward that we can give a more refreshing and more interesting user experiences to our users alike. And in a way to make good use of this YiChat or the Yixin platforms, NetEase got a very good positions on other areas, like the email, the games and things like that, and we would be able to put together what we are currently doing well in other areas, and put on this platforms and to further enhance the communications needs and experiences of the users.

I see. And my second question is on the mobile games pipeline. So I understand that you might not share some of the specific titles, but just wanted to know what type of, let's say, general is the interest for NetEase. Will that be more casual, more social, or will that be more towards the hardcore MMO mobile games? And then related to that, is that -- given that the competition is getting more and more intense in the mobile games so -- and the content differentiations is also getting more and more crowded and less differentiated. So just wondered how do you see the overall mobile game's landscape and the competition level going forward?

Just give us 1 second, Alicia.

[Chinese]

So basically, Alicia, in response to your questions about our mobile games pipelines or the general landscape, I think basically, for whatever type of games, we would also be offering to the market, whether it is the casual one, the social or even the MMO.

Our next question is from the line of Timothy Chan with Morgan Stanley.

I have 2 questions on your international expansion, as well as YiChat as well. So about your overseas licensing strategy, this is the first time you're exporting your titles to overseas. So would that, in any way, imply the growth in China maybe a bit slowing down? And separately on YiChat, could you maybe share with us your target and also, what is the differentiation of YiChat to attract users away from other similar products, this is because user may be -- usually only need only one mobile chatting application on their mobile phones?

So, William [Chinese].

[Chinese]

So basically, with regards to your first questions about the international expansions, because owing to the fact that we believe that our own products got this competitiveness to mobile to the overseas area, and so this would be a natural move. But it doesn't mean that the moving out -- or the licensing of the game titles to overseas means that our own market is not performing well.

[Chinese]

And we are still confident that given the fact that we have some high-qualities game products and some reputable game products in place, we were able to perform quite well by moving a step forward by expanding our footprints in the international area. [Chinese]

[Chinese]

Okay. So basically, there will be quite covers of differentiated competitive niche about our Yixin or YiChat products. First of all, if the users are using the applications within the China regions, basically, there will be certain amount of free usage for them to use it. And with regard to the qualities of the voice or the photo transmissions, our product is of much higher performance than the others. And with regard to the group chat, and we are able to accommodate with over 200 people, that they can do some instant communications, and we believe that this would also be quite welcome to the enterprise and other big organizations to try this special functionalities. And at the same time, we are also -- got a close connections with our emails and also, some other applications to improve the user experiences as such. And also, we always keep an open attitude for cooperating with others for doing some next-generation research and development to make the products much better. And all of these niche of the YiChat products will able to enhance and make a very good experiences for our users in terms of doing their social communications and things like that.

Our next question is from the line of Tian Hou with T.H. Capital.

William and Onward, I have a question related to your mobile game. So in your press release, you mentioned that you're going to issue -- release some several high-quality mobile games. Just by looking at the market, we saw Shanda-issued mobile game, Perfect World-issued mobile game. At the beginning, they were quite successful. However, when Tencent issued some mobile game, they reached to a new level. So it shows that the distribution for mobile game is one of the critical elements in the success of a mobile game. I wonder how you address that issue. William, [Chinese]

[Chinese]

So first of all, William reiterated that the distribution channel is very important, especially for the mobile games strategies. But another area that we also need to pay attention to is about the mobile game's life cycle. In the past 10 years, NetEase has been very successful in proving that the online games, the markets do got a good growth opportunities, and we also got some legendary game titles or classic game titles that has experienced a continued growth in the past 10 years, either achieving some new record high with the numbers, or the new hit records of the revenues, so to call. And on the other hand, it also proved that NetEase is a company that would be able to understand the consumers needs and what the market has been looking for. And we would also be thinking very carefully and seriously in positioning our strategies by moving into the mobile games areas as well. The simple answer to it is that all game genres or the game types will be produced by us. And we would also be make sure that by having some good-qualities game products to the market, to the -- this would get the recognitions from the users accordingly. And at the same time, the reasons why we also move into the area of rolling out another instant messenger application like the YiChat is that we believe that it would also -- lays a good ground for us to set up a platform for distributing our other game titles. And we also believe that the mobile area wouldn't be just accommodating one application at all. And as long as we've got some good applications, we do believe that it would attract the users to install it on their handsets. And so far, people who are having handsets would install quite a couple of applications and maybe [indiscernible]. And as long as you really pay attention to it and seriously do something, and then the products itself is of good qualities, we believe that we would get the recognitions from the market and be able to work it out well.

Onward, I have a question for you. And since you're going to introduce several titles of mobile game in Q4, should we expect the marketing and sales -- sales and marketing expense to go up in Q4?

Well, I think for now, if you're talking about our selling and marketing expenses, because we have still upkeep a general benchmark, because we do not give a specific guidance on how much we would be spending, so far, we would still be upkeep around 10% to 11% of the total revenues as the benchmark of how we are going to spend for this year.

Our next question comes from the line of Jialong Shi with CLSA.

I have a couple of questions. My first question is about your margin trend. Your margin actually have been very resilient in the past couple of quarters, while some of your peers are guiding the margin outlook due to investment into new business, particularly mobile-related business. So can you provide some colors on your margin outlook for next year, and just wonder if you will also see some margin pressure as you guys may probably also decide to kind of ramp up investments into new business? And this is my first question. [Chinese]

So basically, if we are looking forward to the upcoming margin trends because basically, for this year, will be a primary year where we will be doing quite a lot of investment, and we'll not expect that we will do too many other things in the upcoming periods, and we believe that in terms of the margins, then would be a trend that there would be an improvement in this area.

Sorry. So just to clarify, you expand your margin, there could be further upside potential for your margin or?

Well, I think if you are talking about the marketing, in general, because if you're referring to our gaming margins, because you would also see that in the past, that there has been an ongoing trend, in the sense that you would see that we have a more contributions from our self-developed games, and given the fact that we wouldn't still be holding the wheel that this would be the trend going forward. And so in this sense, at least, we will be able to upkeep the current levels of the margins in this sense, but there will be some room for certain improvement.

I see. My second question is on your mobile game. In the earnings release, you guys mentioned the new PC and iPad game called Hearthstone, which seems very promising. Just wonder if you can provide some updates on the feedback so far during the testing phase. [Chinese]

[Chinese]

So basically, first of all, maybe the response to your second question would be that for Hearthstone is still in the testing phase. And so we will not comment too much on how it would go at this point of time, but maybe we'll give you more color at a later point of time when we completed the testing phase. And William has also made another additional supplements on the first question about the margin trend, because we have already do the necessary investments in this area in the past 2 years. And we do -- we are quite confident that we will be able to get some returns or -- especially, starting from next years. And so we would like all of you to understand that this would be the area that we got the confidence, and we are in no way to compare with all the other companies.

Our next question comes from the line of Binnie Wong with Bank of America.

My questions comes on -- just want to -- we see a nice growth on the line -- on the revenue segment on the RVAS [ph]. I just want to understand the -- can you add more color on the growth drivers in this segment? And also, number two is on the use of cash. Given we have almost like a USD 3 billion cash on hand, so I just want to understand what are -- is there any plan in mind for that?

So first of all, if you are talking about the exceptional positive performance of the [indiscernible] and others in the third quarter, the major reason is that we have gotten an increase bring about by the sales of our gaming-related accessories, like the limited edition packs of our New Westward Journey Online II, and this has bring about the growth, especially in third quarter. But if you're looking at the segment in general, because it would be covering quite a lot of stuff like our email, the sale of game accessories and other things, like the e-commerce related kind of stuff like the free tickets and things like that. And so, we are still believing all those different kind of components are progressing well, and we do see that it would result in a nice trend going forward. But having said that, this whole segment is still representing a small portion of our overall business, and so we will still work on this area. And with regards to your second questions about the potential usage of cash, because just as what we previously mentioned, the company has got into 3 potential areas of doing so. First of all, earlier this year, the company has already announced that we would formalize an annual dividend policy, where starting from 2013, we'll be using 22% -- 25% of our net profits for potentially declaring and paying the dividends to the shareholders. And the other thing is that we are still having a share repurchase program in place that will be due to expire by later this month. And another area is that we are still open to some potential investment opportunities.

Our next question is from the line of Jiong Shao with Macquarie.

My first question is about your go-to-market strategy for your upcoming mobile games. Are you considering to do it on your own in terms of promoting and operation? Or are you looking to initially work with platform such as Qihoo and Choyau [ph]? Any thoughts would be appreciated.

[Chinese]

Okay. So basically, for what are the types of our online game initiatives that are going to go -- as to the market, there would be 2 ways that we'll be working on. First of all, we will be working out our own distribution channels or platforms so to call, and we would also make use of what the market is currently using.

Okay. My second question is about your user acquisition for YiChat. We'll appreciate what you just described about the differentiation between YiChat and WeChat basically. But the conventional wisdom is that this sort of chatting program has a pretty strong network of fact. It's great you now have 30 million users already. But going forward, what are some of the ways you are implementing to grab to get more users on your platform to create a much-needed network of that, i.e., like a handset free installation, is that part of it? Anything you can share will be helpful.

[Chinese]

[Chinese]

Okay. So basically, the simple answer to this is that this has been our directions to do it, and we will not stop it until we get it succeeded.

Okay. Can I just follow up, do you consider to do a handset installation to expand your user base?

[Chinese]

So basically, the general [indiscernible] is that there are many, many ways of doing so in order to acquire new users or things like that, whether you are mentioning about the handset free installations and things like that. But the more important thing is that if companies can actually -- are working hard seriously to do some creative stuff or innovations, then we will be able to do some new changes in the upcoming futures. And we do believe that given the passion and the seriousness in our mind of doing in this area, we will be able to work out something good in the upcoming periods.

[Chinese]

Yes. And we do not mean to block out the ways for other people. But what we are currently doing is that we are just finding the ways of working out something that would be more suitable for us.

Ladies and gentlemen, due to time constraints, our last question will be from the line of Alex Yao with JPMorgan. Alex Yao - JP Morgan Chase & Co, Research Division: I have a question on mobile gaming. William, do you think of mobile gaming -- is it more similar to the client-based games or is it more similar to web-based games in terms of monetization, life cycle and the marketing, and what approach will you guys adopt in this gaming genre? [Chinese]

[Chinese]

So basically, I think, it would be quite difficult to give you a very specific answer to what you have been asking. But basically, we are quite sure about how well we should be doing in order to produce a product that can feed the needs of our target users and to improve the user experiences.

Ladies and gentlemen, that concludes our question-and-answer session. At this time, I'd like to turn the conference back over to management for any closing remarks.

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