NetEase, Inc. (NTES) Q4 2011 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the NetEase Fourth Quarter and Fiscal Year 2011 Earnings Conference Call. [Operator Instructions] This conference is being recorded today. At this time, I'd like to turn the conference over to Brandi Piacente, Investor Relations. Please go ahead, ma'am. Ladies and gentlemen, we're experiencing some technical difficulty. [Technical Difficulty]

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 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 corp.netease.com. I will now turn the conference call over to 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 discussion, all percentages are based on renminbi. 2011 was a year marked by considerable growth for NetEase. Our commitment to providing the highest quality content to our [indiscernible] and growing community accelerated our leadership in China's expanding international markets. We achieved dynamic growth across our business segments and increased the total revenues for 2011 by 32% to RMB 7.5 billion or USD $1.2 billion. Online game revenues grew 32.5% to RMB 6.6 billion or USD $1 billion. And advertising services revenue increased 25.6% to RMB 795.4 million or USD $126.4 million. For the fourth quarter of 2011, total revenues increased to 28% year-over-year and 7% quarter-over-quarter to RMB 2.1 billion or USD $341.4 million. Revenues from online games increased to 28.9% year-over-year and 4.4% quarter-over-quarter to RMB 1.8 billion or USD $291.3 million for the fourth quarters of 2011. During the fourth quarter, our fast-growing new self-developed games, Tianxia III, and Ghost grew dramatically. Building on the substantial user base from Tianxia II, Tianxia III generated record revenues and user statistics in the fourth quarter. Similarly, Ghost became one of the most popular 2.5D MMORPG of 2011 in China and reached record user statistics in the fourth quarter. Fantasy Westward Journey and Westward Journey Online II also performed well, benefiting from expansion packs launched early in the year and our successful large-scale promotional activities for these games. Both Fantasy Westward Journey and Westward Journey Online II reached record revenue than 2011. Heroes of Tang Dynasty also delivered a solid performance during the 2011 fourth quarter. Outstanding performances from our self-developed games Ghost, Fantasy Westward Journey, Tianxia III, Westward Journey Online II and Heroes of Tang Dynasty, as well as increased anniv revenues from Blizzard Entertainment licensed game, World of Warcraft, led our growth in online games revenues for the 2011 fiscal year. The increasing popularity of our self-developed online games supports our growth momentum. Our strategy is to continue to diversify and enhance our game content and pipeline to bring our players the highest degree of innovations with new features that enhance their playing experiences. In 2012, we plan to enhance our portfolio of popular games with a variety of expansion packs. We will also introduce new games to further diversify our expansive portfolio. Here is updated plan for the first half of 2012: include an expansion pack for Heroes of Tang Dynasty, Westward Journey Online II, Warsong of Westward Journey, New Fly for Fun and Legend of Fairy. We also plan to begin open beta testing for Ghost and Tianxia III. Two of our new self-developed games are well under development. And we plan to begin beta testing for this new addition in mid-2012. Turning to our advertising services and portal activities. In 2011, revenue growth from our advertising services segment was consistently strong led by the financial services, food and beverages, products and Internet services status. For the fourth quarter, advertising services revenue increased to 26.3% sequentially and 90.2% year-over-year with automobiles, Internet services and financial services as our top-performing verticals. Our email user base grew rapidly in 2011. Both newly registered and active email users reached record high user numbers in the fourth quarter. Further solidifying our position as the #1 free email provider in China. At the end of 2011, our registered email users statistic has grown to 430 million users, an increase of 4.7% over the third quarter. Similarly, the number of micro-blogging users grew to 97.6 million, an increase of 10.3% over the third quarter. We continue to evaluate the market and introduce new products and service offerings that meets the requirements of the dynamic Internet industry. During the year, our innovations was recognized by PC Magazine as our technologically advanced beta-testing [ph] products were named in the publication as the best products of 2011. This year, we will be focusing on enhancing our product applications and introducing new mobile services and contents that further demonstrate our focus on quality and innovation. We hold a long history of cultivating a loyal and receptive communities of Internet users in China. And to creating new products and services that drive strong user traffic are central to our continued expansion. Our main priority for 2012 is to continue to satisfy China's Internet users by providing unique and high-demand products and services to the market. This concludes William's update on games, advertising and portal. Now I will provide a review of our fourth quarter and full year 2011 financial results. I will primarily focus on the discussions of market and expense fluctuations along with net profit. Beginning with fourth quarter 2011 results. Gross profit for the fourth quarters of 2011 was RMB 1.5 billion or USD $230.9 million. This compares to RMB 1.3 billion and RMB $1.1 billion for the preceding quarter and the fourth quarters of 2010, respectively. The quarter-over-quarter and year-over-year increases in gross profit were primarily attributable to increased of revenues from both our online games and advertising services businesses, partially offset by increased cost of revenues such as royalties and consultancy fees related to licensed games operations and increased staff-related costs. Our highest performing games in the fourth quarters were Tianxia III, Ghost, Fantasy Westward Journey and Westward Journey Online II. These quarter-over-quarter and year-over-year increases in games revenues were primarily attributable to increased of revenues from our self-developed games, which was partially offset by a decline in revenues from Blizzard Entertainment's World of Warcraft in the fourth quarter. The quarter-over-quarter and year-over-year increases in advertising services revenues were primarily attributable to seasonalities and the increasing appeal of our portal to users and advertisers, and improved portal and search traffic on our NetEase website. Gross profit margin for the online games business for the fourth quarters of 2011 was 72.6% compared to 71.5% and 71.8% for the preceding quarter and the fourth quarters of 2010, respectively. For the fourth quarter of 2011, gross profit margin for the advertising business was 54.5% compared to 48.4% and 53.5% for the preceding quarter and the fourth quarters of 2010, respectively. The quarter-over-quarter increase in gross profit margin was mainly due to economies of scale as advertising revenue increased in the fourth quarter without a corresponding increase in advertising-related costs. Gross profit margin for our Wireless Value-Added Services and Others business for the fourth quarters of 2011 was 2.2% compared to gross loss margins of 13.2% and 19.7% for the preceding quarter and the fourth quarters of 2010, respectively. The quarter-over-quarter and year-over-year improvements in gross profit margin were mainly due to increased revenues from our e-commerce business and mailbox services. Total operating expenses for the fourth quarter of 2011 were RMB 529 million or USD $84 million, compared to RMB 408.2 million and RMB 320.7 million for the preceding quarters and the fourth quarters of 2010, respectively. The quarter-over-quarter increase in operating expenses was primarily due to increased of selling and marketing expenses, mainly resulting from increased marketing promotional activities for Tianxia III, World of Warcraft and Ghost, and increased research and development staff-related costs, as well as an impairment provision of RMB 50.3 million or USD $8 million on the initial online game license fees of Blizzard Entertainment's StarCraft II. The year-over-year increase in operating expenses was primarily due to increased selling and marketing expenses, staff-related costs and the aforementioned impairment provisions in general and administrative expenses. Net profit for the fourth quarters of 2011 totaled RMB 898.6 million or USD $142.8 million compared to RMB 825.8 million and RMB 712.5 million for the preceding quarter and the fourth quarters of 2010, respectively. During the fourth quarter of 2011, we reported a net foreign exchange loss of RMB 36.4 million or USD $5.8 million compared to a net foreign exchange loss of RMB 65 million and RMB 36.4 million for the preceding quarter and the fourth quarters of 2010, respectively. The quarter-over-quarter and year-over-year foreign exchange losses were mainly due to the exchange losses arising from our euro-denominated bank deposit balances as of December 31, 2011, as the exchange rate of the euro against the RMB fluctuated over the period. We reported basic and diluted earnings per ADS of USD $1.09 each for the fourth quarters of 2011. This compares with basic and diluted earnings per ADS of USD $1 each for the preceding quarter and basic and diluted earnings per ADS of USD $0.87 each for the fourth quarters of 2010. We recorded a net income tax charge of RMB 122.6 million or USD $19.5 million for the fourth quarters of 2011 compared to RMB 140.5 million and RMB 83.2 million for the preceding quarters and for the fourth quarters of 2010, respectively. The effective tax rate for the fourth quarters of 2011 was 11.8% compared to 14.7% for the preceding quarter and 10.3% for the fourth quarter of 2010. Our various principal subsidiaries enjoyed the preferential enterprise income tax rate of 15% as High and New Technology Enterprises from 2008 to 2010. As these subsidiaries have recently renewed their qualifications as New and High Technology Enterprises (sic) [High and New Technology Enterprises] the preferential enterprise income tax rate will remain in effect for 2011 through 2013, subject to annual review by the relevant tax authorities in China. Now turning to the fiscal year 2011 financial results. Gross profit for fiscal year 2011 was RMB 4.9 billion or USD $781.4 million compared to RMB 3.7 billion for the preceding fiscal year. The increase in gross profit for fiscal year 2011 was primarily driven by increased revenue, partially offset by increased cost of revenue from the online games and advertising services businesses. Total operating expenses for fiscal year 2011 were RMB 1.6 billion or USD $253.4 million compared to RMB 1.2 billion for the preceding fiscal year. The increase in operating expenses in 2011 was primarily due to increased selling and marketing expenses, comprising mainly marketing and promotional activities for Ghost, Heroes of Tang Dynasty, Blizzard Entertainment's World of Warcraft and StarCraft II and increased staff-related costs, resulting from increased headcount in the general and administration and research and development areas, as well as the impairment provisions on the initial online game license fee, that I previously mentioned. Net profit for fiscal year 2011 totaled RMB 3.2 billion or USD $513.9 million compared to RMB 2.2 billion for the preceding fiscal year. For fiscal year 2011, we reported a net foreign exchange loss of RMB 79.1 million or USD $12.6 million. This compares to a net foreign exchange loss of RMB 89.5 million for the preceding fiscal year. The net foreign exchange losses for 2011 and 2010 were mainly due to exchange losses arising from the company's euro-denominated bank deposit balances as the exchange rate of the euro against the RMB fluctuated over this period. We reported basic and diluted earnings per ADS of USD $3.93 and USD $3.92 for fiscal year 2011, respectively. This compares to basic and diluted earnings per ADS of USD $2.74 and USD $2.72 for the preceding fiscal year, respectively. We recorded a net income tax charge of RMB 392.8 million or USD $62.4 million and RMB 344.4 million at an effective tax rate of 10.9% and 13.4% for fiscal years 2011 and 2010, respectively. As of December 31, 2011, our total cash and time deposit balance was RMB 11.9 billion or USD $1.9 billion compared to RMB 9.5 billion as of December 31, 2010. Total held-to-maturity investments balance was RMB 993.6 million or USD $157.9 million as of December 31, 2011. There were no such investments as of December 31, 2010. Cash flow generated from operating activities was RMB 1.2 billion or USD $197.6 million for the fourth quarter of 2011 compared to and RMB 864.9 million and RMB 901.5 million for the preceding quarters and the fourth quarters of 2010, respectively. On December 1, 2011, our Board authorized a share repurchase program of up to USD $50 million of NetEase outstanding ADSs. No ADSs have been repurchased as of December 31, 2011. The share repurchase program will end on February 29, 2012.

Thank you, Onward. Due to the technical difficulties at the beginning of the call. I need to reread the Safe Harbor Statement that will cover the discussion for today. So please note the discussion today has contained forward-looking statements or may have contained forward-looking statements relating to the 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 has been recorded and is currently being recorded. You can also find the webcast replay of the call on the company website at corp.netease.com. So we'd now like to open the call up to questions. Operator?

[Operator Instructions] Our first question comes from the line of Richard Ji with Morgan Stanley.

I have 2 questions. First of all, to offer your new sales developed games including Tianxia II and the Ghost delivered record performance. Can you possibly give us a little more color and on the status of these games and hopefully, user volume and the revenue contribution? Can you also rank your games in terms of the total sales contribution? William, [Chinese]

[Chinese]

[Chinese]

[Chinese]

So in terms of user information statistics, I think given the fact that the company's by now has quite a lot of game products in place in operations, and so we consider... [Audio Gap] Sorry, okay. Just recap on what William has just highlighted on Richard's questions. For the user information, we consider that it is not appropriate to disclose given the fact that by now, many users got quite a lot of game products in place and in operations. And insofar as the performance of Tianxia III is concerned, the company has put in a very good assets to put forward a comprehensive upgrade of the Tianxia II to Tianxia III. And revenue contributions from the Tianxia III products is much higher than the Ghost one, given the fact that the product incentive already in place in the markets for some time and also into the fact that the Ghost has only been operated within a 1-year time span. And given that we have also rolled out some new expansion packs to enrich the game content and game play features to Tianxia III, we do look forward that to see how the market will respond to this new comprehensive upgrade products. Thank you.

That's helpful. And my second question is about your partnership with Blizzard. And for 4Q and World of Warcraft showed some weakness. Should we expect World of Warcraft, Ghost to reaccelerate in the coming quarter? And can you also comment on your plan to further your partnership with Blizzard and for Battle.net, StarCraft and any future new games? William, [Chinese]

[Chinese]

So in terms of the performance of the World of Warcraft, I think basically, the responses of the product in the markets was very much depends on the game play, the features and the content and whether there would be a sufficient and rich contents to attract and to keep the players. And we do believe that the World of Warcraft is a traditional and a very reputable game product and we do have confidence on the features of operating the physical [ph] product as well. And insofar as the cooperations with Blizzard is concerned, we do maintain a good and smooth cooperations with the Blizzard side, and Blizzard is also a very respected partners on a worldwide scale. And we do look forward -- we do have further cooperations in this area.

Our next question comes from the line of Wallace Cheung with Crédit Suisse.

I think my first question is on the operating expenses. It seems like the company has increased quite a bit of expenses in fourth quarter. How do we see the expenses grow in the first quarter this year? Which line will -- growing stronger and in particular on the R&D side, are you going to hire more people in the first quarter? And second question will be on the new business as we've seen NetEase in the last couple of months, I actually have been quite active in getting to new area, i.e., the online video, the animation business and also the enterprise email. Can William and Onward give us a bit more insight about how do we see NetEase potential new business and any kind of a financial impact? Do I have to translate it? [Chinese]

[Chinese]

[Chinese]

[Chinese]

[Chinese]

[Chinese]

[Chinese]

So first of all, maybe I just do a quick recap on William's highlights or Will's perspectives on the new business in different areas. First of all, for the online video developments, I think lately, I think quite a lot of you would be aware that NetEase has been getting to cooperation with LotKiwi [ph] in order to broaden our online video service offerings. And we do believe that through this cooperations this will also make sure that we can have a much better user's experiences for our portal users by providing some high qualities online video playing experiences. And also this would be also another area, value-added services that we are currently offering to our users. And in terms of the animations of the area, I think basically, this would be quite in line with what we are currently doing for our online game business. In fact, we would continue to increase our assets in the R&D area in order to roll out more new products to the market. And we do view that the new tryout in the animations area would be another form of enriching our content deliveries in order to diversify our overall service delivery to the market. And in terms of the enterprise email, basically, I think this would be a kind of service facing the enterprises and the small- and medium-size enterprises in public work. And up to now, through the launch of these services in last year, we've got a very good feedback and responses from the market. And these services is actually -- is also well-received by that. And by now, we have over 40,000-plus paying users using these services, and we do hope that this would help out quite a launch to the SME, the small and medium enterprises in terms of improving their communications to their business partners alike. And on the other hand, maybe I will just supplement it. What is the second question about the operating expenses out log of the companies in 2012 or so because you are well aware that in the fourth quarters of 2011, there has been a little bit increase in terms of the operating expenses. But basically, I think it was mainly attributed to an impairment loss or impairment provisions of RMB 50.3 million for the initial license fees relating to the StarCraft -- StarCraft II products. And other than that, I think in terms of the other lines of the operating expenses, so to call it selling and marketing expenses, G&A and also research and development expenses, I think this would be quite as stably growing to cope with the expansions of the communist business.

Our next question comes from the line of Dick Wei with JPMorgan.

I also have a questions on the R&D front. Onward, can you explain where did the RMB 50 million book businesses on the R&D line? And then also, if you can discuss about the headcount plan for R&D for 2012, that would be great. William, [Chinese]

[Chinese]

In terms of the company's vision, so the strategies on the building the headcount of the company, I think as an innovative and technologically strong company, we do place ample importance or the priorities on our R&D people. And for our long-term people development strategy, I think lately, some of our peers may slow down their recruitment program, but this is not the case for NetEase. And for ourself, we do still continue with our momentum to attract and retain the best talent in the market. And we do also offer a very competitive and good package to achieve that goal. And [indiscernible] Yes. Please go ahead, Dick.

I wanted to ask you about where did the RMB 50 million booked for StarCraft?

The RMB 50 million -- are your relating to the impairment provisions of RMB 50 million?

Right.

This has not been gone through to the R&D line but instead it has gone through the G&A line, G&A line. And so you see that for the fourth quarters, our G&A expenses has increased by almost RMB 40 million to RMB 50 million. And basically, this would be the impact relating to the impairment provisions that's worth paying.

Okay, great. And then my second question is on the plans for social and mobile games. William, [Chinese]

[Chinese]

With regard to our strategies on the social and mobile game front, basically, we have rolled out a new product on both the iPhone and also the iPad, a little games called Magic Book. And this will be a totally new experiences, a new try on this part of the market. And in terms of the social game front, I think we also were finding a new and unique way of developing some new games in this area. And we would give you more information as we see fit.

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

I have 2 questions. Number one, can you guys share the reasons for the impairment provisions on the StarCraft licensing fee? Does that mean that the game has not met up the expectation? And then any future impairment charge for the minimum guaranteed portions?

I think first of all, regarding your questions on the impairment provisions, I think this is just an ongoing review and assessment of the performance or the operations of the games. And this is also an accounting treatment to align with the required expenses that we need to go in to and to account for them. But in no way, we do still believe that the game itself is operating well. And given the fact that we have done quite a lot of marketing and promotional events and activity so far, throughout the year to make the game more readable and more apparent to the market, we also received some very good and positive responses from the market as well for it, the StarCraft II. And with that if you -- you might also infer that on the 23rd of this month, we will also roll out an unlimited editions of playing this game by paying fees for the StarCraft II, which we believe will be a very convenient and economical way of putting forward the games to potential and existing players. And we do still believe that this kind of -- these host games will get a good presence in the China market.

I see. And second question is I understand that NetEase actually had a number of web games released or under development. I wanted to get management view on the overall web game markets? And how fast do you think these markets can grow in the next few years versus to the traditional MMO market?

[Chinese]

[Chinese]

So with regard to our strategies on the web game developments, currently, we do have a few games in developments and we would also push forward in the market later on. And still, at this point in time, we believe that the client base game got a much better presence than the web games. But having said that, we do still believe the rollout and the developments of the web games would create a supplement to the existing user experiences of our online game products.

Our next question comes from the line of Eddie Leung with Merrill Lynch.

Could you help us to understand what you have seen in the advertising market this year? Have we seen any slowdown in advertising growth from your advertisers? William, Onward, [Chinese]

[Chinese]

So basically, with regard to our views on the advertisers market, basically, I think the macro environment would definitely cause some impact to the advertisers businesses. But having said that, we do still believe that there are much rooms to further explore and further develop in terms of the NetEase portals. Say, for example, we are the biggest free email service providers. And by the end of 2011, we have a registered users of 450 million registered users. And in terms of the active and unique users, the number would be about 100 million plus. And at the same time, we do believe that a diversified content delivery would also pose another room of opportunities in the advertisers business. And you would also see that by way of cooperating with the LotKiwi [ph] in terms of providing a much more comprehensive and diversified online video contents, we do believe that this would get a very good and positive potentials in the service usage. And by now, we do also see that the user's behavior or the habits will not solely just watching news or just sending emails and they are also expecting much more. And we do believe that by taking the various new measures that -- or the new products or new services that we're going to offer to the market, this would post a positive opportunities to NetEase.

Our next question comes from the line of Martin Bao with CICC.

My question is regarding to the...

I'm sorry, the line is not very clear and we can't hear you clearly.

My question is regarding to the wireless value-added and other services and we see that it recorded a positive growth margin in the fourth quarter. And could you kindly give us some color of your expectation on this business in 2012? [Chinese]

[Chinese]

In terms of our strategies or the views on the wireless value-added services and others business in 2012, basically, we have been putting a very hard efforts to try out some new businesses in this area. And at all times, we do want to deliver very good services to the market. The process is difficult, challenging but yet exciting. And we do feel that by putting out some new business or new product and services to the market, we would also experience some positive impact on the Internet arena.

Our next question is from the line of Ming Zhao with SIG.

Two quick questions. First question is on the capital expenditure and second question is on your game pipeline in this year. [Chinese]

Maybe I will answer the first question regarding the CapEx one first and then I will request William to give you some supplement on the game pipeline in 2012. In terms of the CapEx in the fourth quarters, you will see that there has been a significant increase as compared with the third quarters. And there has been some expenditures that we have spent in purchasing properties and office building in the Beijing area. So William? [Chinese]

[Chinese]

[Chinese] With regard to our new game pipelines in 2012, I think definitely some new kinds of games that we're going to roll out in 2012. And one of those that William would like to highlight is about a game called Datang. And this game itself is not a pure MMO game but rather this game would focus more on some visual and operating experiences to the players. And at the same time, we also got some other games currently in development process. And at the moment, we think we will not disclose the exact names of it for the time being but definitely, we would give up more color and details on the upcoming quarters.

And at this time, I turn the conference back over to Brandi Piacente.

Thank you, everyone, for joining us today. Please feel free to contact us if you have further questions, and have a great day.

Thank you. Ladies and gentlemen if you'd like to listen to a replay of today's conference, please dial 1(800)406-7325, or 1(303)590-3030, using the access code of 4507729 followed by the # key. This does conclude the NetEase Fourth Quarter and Fiscal Year 2011 Earnings Conference Call. Thank you for your participation. You may now disconnect.