NetEase, Inc. (NTES) Q1 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the NetEase, Inc. First Quarter 2012 Earnings Conference Call. [Operator Instructions] This conference is being recorded today, May 16, 2012. I'd like to the conference over to Ms. Brandi Piacente. Please go ahead.

Thank you, operator. Please note, the discussion today will contain forward-looking statements, relating to future performance of the company, and are intended to qualify for the Safe Harbor from liability as established by the U.S. Private Securities Litigation Reform Act. Such statements are not guarantees to 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 in 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 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. We have a long history of innovations that has helped to shape China's evolving Internet market. Throughout this development, we have established a deep understanding of the market appetite and a commitment to providing our growing community with relevant, high-quality content and services. In the first quarter, we continue to improve our results, with total sales increasing 30.3% year-over-year to RMB 2 billion, or USD $318.2 million. Led by strong sales from our self-developed games, our total online games revenues increased 31.4% to RMB 1.8 billion, or USD $289.2 million, compared with the same period last year. This growth was based on increasing revenue contributions from our newer games, Ghost and Tianxia III, as well as several of our flagship games like Fantasy Westward Journey, Westward Journey Online II and Heroes of Tang Dynasty. Our successful executions of our online games strategy and increase in revenue from our newer games, has been the result of our continuous improvement of our gamers' user experience, which was further demonstrated by Ghost's performance in the first quarter. Due to full-scale closed beta testing in September, Ghost has grown rapidly, quickly establishing a stable user base and strong revenue stream. Last month, we launched open beta testing for this game to introduce new features, such as cross-server interactions, arena combat, and other new content. The player response has been positive, and we are quite pleased with this game's strong performance to date. Our 3D game, Tianxia III, has also grown dramatically. Benefiting from its unique and innovative game play mode, Tianxia III achieved record-high revenue in the first quarter. We are working to introduce additional exciting content for this game, and we plan to launch, open beta testing for Tianxia III in the second quarter. Fantasy Westward Journey and Westward Journey Online II were also standout performers in the first quarter. We plan to build on this momentum with large-scale promotional activities and new expansion packs for this game in the second and third quarters. We have a robust pipeline plan for 2012, and plan to launch a number of expansion packs or new game versions in the second quarter, including Heroes of Tang Dynasty, Westward Journey Online III, and Warsong of Westward Journey. In additions to our expansion packs, we plan to build and diversify our portfolio through the introductions of new self-developed games. Our newest games under development are progressing well and in the second quarter. We plan to initiate beta testing for all new games: A 3D ARPG called Soul of Warrior; Wu Hun, a 2.5D MMORPG; Heroes of Three Kingdoms, a 3D action realtime strategy or DotA game; and Dragon Sword, a next-generation 3D action MMORPG. These highly anticipated games highlight our innovative content and strong R&D capabilities as we continue to bring leading game technologies to China's Internet market. With respect to our licensed games, we are pleased to have renewed our contract with Blizzard Entertainment to continue our existing cooperations on Blizzard Entertainment's World of Warcraft in Mainland China. We look forward to releasing Mists of Pandaria, the book [ph] Expansions to World of Warcraft in Mainland China as soon as possible. Turning to our advertising services and portal activities. Despite the seasonally slow quarter, our advertising revenue grew by 13.1% year-over-year, led by automobile, Internet services, and food and beverage services as the top-performing sectors. Quarter-over-quarter, the advertising revenues declined 48.5%, which reflects the typical industry seasonality. We expect the user increase in advertising's revenues in the second quarter and through the second half of 2012 with an added benefit from our planned activities at the London Olympics. Internet and online video advertisements are growing in popularity, and we are well aligned to benefit from these trends by providing users with excellent online video services. During the first quarter, our portal traffic grew steadily as we continue to focus on increasing our appeal to users by increasing dynamic content, synthesizing user feedback and providing service integration between different mobile device platforms. To leverage the opportunities as to the upcoming London Olympics, we will be working with our content provider partners to offer the most up-to-date and in-depth coverage of this exciting event for our portal and mobile Internet users. Our news app product will play a key role in our mobile coverage. This application has grown quickly in popularity, capturing terrific user attention and acclaim. In the first quarter, it was one of the most highly ranked news application for iOS and Android platforms. Our micro-blogging and e-mail services also continue to expand. In the first quarter, the number of micro-blogging users grew to 121 million, up 24% from December 31, 2011. Similarly, our users -- e-mail users grew by 6.7% quarter-over-quarter to 480 million registered e-mail users as of March 31, 2012. Our corporate mailbox services have also grown considerably. In the first quarter, we were named one of the top corporate mailbox service providers in China after only 3 years since we first launched this service. NetEase has built a strong foundations with broad offerings across our online game business, search services and total operations. We continue to build on these fundamentals by directing innovative content, advanced technology, and high-quality entertainment services that appeal to users of all ages and interests across China. Our loyal customer base has secured us a leadership position in the Chinese Internet market for more than 13 consecutive years. And we expect 2012 will prove another prosperous year for our company and our followers. This concludes William's update. Now I will provide a review of our first quarter 2012 financial results. I will primarily focus on the discussions of margins and expense fluctuations, along with net profit. Gross profit for the first quarter of 2012 was RMB 1.3 billion, or USD $211.4 million. This compares to RMB 1.5 billion and RMB 985 million for the preceding quarter and the first quarter of 2011 respectively. The quarter-over-quarter decrease in gross profit was primarily attributable to a seasonal decline in advertising's revenue. The year-over-year increase in gross profit was primarily attributable to increased revenues from our self-developed games, Ghost, Tianxia III and Fantasy Westward Journey, which were partially offset by a decline in revenue from Blizzard Entertainment's World of Warcraft. Gross profit margin for the online game business was 73%, compared to 72.6% and 70% for the preceding quarter, and the first quarter of 2011 respectively. Gross profit margins for the advertising business was 19.8%, compared to 54.5% and 33.4% for the preceding quarter and the first quarter of 2011 respectively. The quarter-over-quarter decrease in gross profit margin was primarily due to a decline in advertising revenues as explained above. The year-over-year decrease in gross profit margin was primarily due to increased headcount-related costs and content purchase costs in the first quarter of 2012. Gross loss margins for our e-mail, WVAS and others business was 18%, compared to a gross profit margins of 2.2% and gross loss margins of 21.6% for the preceding quarter and the first quarter of 2011 respectively. The quarter-over-quarter change was mainly due to increased customer services costs and technologies support costs in the first quarter of 2012. Total operating expenses were RMB 355.7 million, or USD $56.5 million, compared to RMB 529 million and RMB 292 million for the preceding quarter and the first quarter of 2011 respectively. The quarter-over-quarter decrease in operating expenses was mainly due to the fact that there were less selling and marketing promotional activities in the first quarter of 2012. In addition, an impairment provisions of RMB 50.3 million on the initial online game license fees for Blizzard Entertainment's StarCraft II was recovered in the fourth quarters of 2011. The year-over-year increase in operating expenses was primarily due to increased headcount-related costs and increased research and development costs related to product development. Net profit for the first quarter of 2012 totaled RMB 941.7 million, or USD $149.5 million, compared to RMB 898.6 million, and RMB 737.4 million for the preceding quarter and the first quarter of 2011 respectively. During the first quarter of 2012, we reported a net foreign exchange gain of RMB 17.6 million, or USD $2.8 million, compared to a net foreign exchange loss of RMB 36.4 million, and a net foreign exchange gain of RMB 25.3 million for the preceding quarter and the first quarter of 2011 respectively. The quarter-over-quarter and year-over-year changes in foreign exchange gains and losses were mainly due to the exchange gains and losses from euro-denominated bank deposit balances as of March 31, 2012, as the exchange rate of the euro against the RMB fluctuated over the periods. We reported basic and diluted earnings per ADS of USD $1.14 each for the first quarter of 2012. This compares with basic and diluted earnings per ADS of USD $1.09 for the preceding quarters, and reported basic and diluted earnings per ADS of USD $0.90 and USD $0.89 respectively, for the first quarter of 2011. We recorded a net income tax charge of RMB 163.1 million, or USD $25.9 million, compared with RMB 122.6 million, and RMB 57.2 million for the preceding quarter and the first quarter of 2011 respectively. The effective tax rates for the first quarter of 2012 was 14.9%, compared to 11.8% and 4.8% for the preceding quarter and the first quarter of 2011 respectively. Our various principal subsidiaries renewed their qualifications as High and New Technology Enterprises in 2011, and we'll continue to enjoy the differential enterprise income tax rate of 15% from 2011 to 2013, subject to annual review by the relevant tax authorities in China. The quarter-over-quarter increase in the effective tax rate was mainly due to the expirations of the enterprise income tax expansion period for certain subsidiaries that were qualified as Software Enterprises, which resulted in an increase in the applicable tax rates from 0% to 12.5%. The year-over-year increase in the effective tax rate was primarily due to the recognition... [Technical Difficulty] Sorry. As of March 31, 2012, our total cash and time deposit balance was RMB 13.1 billion, or USD $2.1 billion, compared to RMB 11.9 billion as of December 31, 2011. Cash flow generated from operating activities was RMB 1.3 billion, or USD $212.3 million for the first quarters of 2012, compared to RMB 1.2 billion and RMB 969.3 million for the preceding quarter and the first quarter of 2011 respectively. Thank you for your attention. We will now be happy to take your questions. Operator, please go ahead.

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

My first question would be, you have today reached in-house-developed game pipeline. And can you please talk about which games you have high expectation on? And how are these games different from other games in the market? And I have a follow-up question.

[Chinese]

[Chinese]

So the highlights of William's comments and remarks on Timothy's first questions regarding this potential or the differences of our new launch of the games to the market were basically, summarized as follows: In 2012, basically, the various launch of our games in the markets were mainly distinguished by the different game genre or different game types that we're going to launch to the market. And for examples, there would be some new game pipeline, the DotA games, and some games like the ARPG games, such as the Soul of Warrior that we're going to launch. As for our own R&D capabilities with regard to the MMORPG games, definitely, NetEase is very strong in this area, and we have already come into the next generation in terms of our development capabilities. And we also believe that in terms of our artwork, the total levels or the qualities of our artwork delivery would be further enhanced and increased. And for the new games that we are going to launch for this year, definitely, we would have some good expectation to them. But having said that, well, we would still make a remark that we would like to see until -- in the first quarter of this year when we roll the games, and see how it would performs in the market.

Okay. My second question would be, maybe could you talk about your M&A strategies? As according to some news report on, you have allocated RMB 2 billion to a we see fund [ph], what areas are you looking at, and what are the investment criteria?

[Chinese]

I'll answer. Okay. So basically, with regard to the company's M&A strategies, I think you are quite right in saying that the company's have set aside about RMB 2 billion -- dollars to do -- to work on this area. And basically, we would be investing in some initial to -- or early-stage to the industry with regard to our businesses, just like the Internet-related business. And of course, at the moment, we're working on it and we will give you more color as we get into more details.

And our next question comes from the line of Alicia Yap with Barclays.

Very quickly, number one is that, I wanted to get some color on how should we think about the sales and marketing expense in the second quarter and going forward, given that you're going to be releasing a number of the new games and expansion packs in the coming months?

[Chinese]

[Chinese]

So basically, based on -- William has commented that for the upcoming quarters, expecting on the general marketing, of course, there would be an increase because traditionally, the first quarter would be the low season, and given the fact that there will be the Chinese New Year event as well. So usually, we would be deploying less resources or money in doing the promotion, and things like that. And given the fact that in the upcoming quarters, we would have some new games and new product out to the markets, and we will upkeep a reasonable percentages of our selling, marketing expenses spending in this area.

I see. And second question is that, can you comment on the general advertising demand environment in the second quarter, and if you have any visibility into the second half? And then with that, have you started to receive, or seen some Olympics-related ad spending so far?

[Chinese]

[Chinese]

So basically, this year would be the launch of the Olympic after a 4-years period and basically, we are -- already get that and prepare ourselves to reap the benefits of the London Olympics for this year. And up to now, we also anticipated that there would be some new demand, especially the advertising demand with regard to the London Olympics for this year. And for the overall outlook for this year, we still hold a positive view about the general advertisings business.

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

I have 2 questions. First question is on the web games side. I wonder, many of the MMORPG companies, they are trying to get into web game market. I wonder what William thought on the potential success for these companies? And what about the plans for NetEase, and how was NetEase different from these company in terms of web games development? [Chinese]

[Chinese]

So basically, we also place some importance on the new change of the trend in the gaming market from the MMO towards the web games area because this would be a new game mode in the overall market, and of course, for NetEase, we do have a few game titles trying out in this area, and we will still continue to look how this would be going. And basically, for the web games and the MMORPG games, basically, those 2 types of games are quite similar, except for the fact that for the MMORPG games, the players will need to download the client base before they would be able to play the games. And overall sense, we would upkeep a relatively calm [ph] attitude towards its development for the time being.

Great. And my second question is on mobile monetization. [Chinese]

[Chinese]

Okay. So with regard to the mobile monetizations, at the moment, we do not have any specific plan yet, but we do -- with regards on this platform, you see very good ways for us to launch various kind of user tools or to facilitate the users to make use of their [indiscernible] times. Up to now, for NetEase, we do have our news applications, the reading applications, the notes app from Youdao, and also the dictionary and stuff like that. And we do believe that this would be a very good ways for us to have a good offerings of new applications on this platforms to facilitate the users' experience in this area.

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

I have 3 quick questions. Number one is although we understand that the Diablo III launch day and contract is not that clear, but given what we have seen, the strong performance in U.S. and also in Korea, how would management think, when is Diablo III going to be launched in China? Would there be any potential impact on the rest of the games of NetEase? Second question will be on the R&D expenses. It seems like you still kind of quite differently [ph], in particular in the share-based compensation expenses. I think in last couple of quarters, it's actually gone up a lot. Is NetEase hiring more engineers? And also, are you paying more higher salary to sort of attract good talent? Final question will be, I think I have asked this question many, many times. Unfortunately, there are a lot of new media report recently again on NetEase's potential shipment of handset. I don't know what's the reason behind, but I just want to get a very quick final comment. [Chinese]

[Chinese]

[Chinese]

[Chinese]

Okay. I think with regard to Wallace's 3 questions, maybe I recap the highlights from William's remarks one-by-one. With regard to Wallace's first question on the D III, the best potential impact to China and especially to NetEase, I think what NetEase is doing, is that we are still in progress of preparing for the Diablo III and we -- for whatever new launch of the games to the markets, we do emphasize the importance of the user experiences, and we would try to make sure that the user experiences will be secured before the launch of this game in the market. And on the second questions regarding the increase in the R&D expenses, or the related SBC expenses, I think this would just be a reflection on how we focus on the human capitals within NetEase, and how willing and -- that NetEase would be willing to invest on the human capital in order to make sure that we are a very competitive company. And on the other hand, the increase in the R&D expenses would be another reflections on how confident, that we would like to make sure that the long-term developments of the company would be secure. And at the same time, given the very competitive environment or the landscape in today's Chinese markets, we also believe that it would be a good thing for us to [indiscernible] some of the good results with our staff in general. And for the third questions regarding the potential shipments or the launch of our own handsets. This is one of the topic that we are -- currently, seriously considering

Just 2 quick follow-up. One is regarding the Diablo III, do we see this quite significant overlap between the Diablo III and the World of Warcraft users? And so will the kind of launch will have any kind of potential cannibalization? Second point will be on the R&D expenses. So can we have an update on the total number of headcounts, especially in R&D count by the end of the first quarter?

[Chinese]

Okay. Basically, Wallace, with regard to your first follow-up questions regarding the Diablo III, I think basically, we do not comment, or do any projections on how it will be doing upon the launch of this game to the market. And for your second follow-up questions regarding the R&D headcount up to the end of the first quarter of 2012, it would be somewhere around 1,700 people.

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

I have a few questions. You mentioned on the -- on your earning release that you have a few new games ready for beta testing across the full-length [ph] Quarters. So could you provide a little bit more details, like the respective quarter do you expect to rollout these new games? And also, if I remember correctly, Soul of Warrior, already started, closed beta testing in April. So how is the performance of this game during the testing? [Chinese] I have a follow-up question.

[Chinese]

So basically, with regard to Jialong's first questions, for the launch of our new games for this year, basically we would have schedules geared towards the second shipment [ph] for this year, and we will give more color as we come closer and perhaps, get more announcements on our official website. And with regard to the comparison with -- on the close beta testing of the Soul of Warrior, which is some other games like the Ghost, because those 2 games are quite different in nature, one would be an ARPG games, the other would be MMORPG games. So basically, they're not very comparable in this sense. And also, we still want to take some more times to look at how those new games would be performing after the closed beta testing.

My next question is about Dragon Sword, and could you provide more -- some colors on this -- on the unique features of this game, compared to those existing games in the market? [Chinese]

[Chinese]

So basically, our development team on the Dragon Sword product has got a very strong 3D planned experiences in -- on this type of game. And we also anticipated that through the -- our efforts in developing this new game, they would be able to bring some new experiences to the gamers in general in the China market.

I asked my last question on your e-mail service. And you mentioned on the earning release, you now have 480 million subscriber, e-mail subscribers. So just wondering if you could provide any data points, like the daily or monthly active users for your e-mail services, and also how many users for your corporate e-mail service. [Chinese]

[Chinese]

So on a monthly basis, basically, our active users who would be logging into our e-mail services will be over 100 million, and for e-mail users, users would be over 40,000.

And our next question comes on the line of Martin Bao with CICC.

And a question regarding the Fantasy Westward Journey and the Westward Journey II. And we have seen that you have introduced innovative and a new feature seeing some newer games like the Ghost and Tianxia III, and I would like to know the update and upgrade plan. And do we have any plan to introduce those new features into the old ones -- to older games in our portfolio? [Chinese]

[Chinese]

So basically, we are always striving to make many new innovations to our existing game play to various game products and improve some new innovations or the creation of some new game features. Of course, we will be able to try to share something that is really well received or popular amongst different games. This is always our philosophies of running our gaming business.

And our next question comes from the line of Mark Marostica from Piper Jaffray.

My first question is in regards to the new expansion pack for World of Warcraft, Mists of Pandaria. And I would like to get your thoughts as to how different this expansion pack is for the franchise, and whether or not William thinks it will rejuvenate the game going forward? And then I have a follow-up question.

Okay. Mark [Chinese] Okay. So basically, Mark, the -- your questions regarding the new expansion pack, I think at the moment, I think what we can share with you is that, it's still well underway and there's not much we can share for now, but keep -- let's stay tuned with our official announcement, and perhaps, stay -- if you take a look at our official website from time-to-time [indiscernible] come to a more suitable time.

Okay. And then a second question regarding the advertising business, you talked about investing in content purchases and headcount-related costs in the first quarter, and I'm curious whether or not we should expect to see the second quarter bear the same level of activity on the content and purchase front and headcount side, or if the bulk of that was taken care of in the first quarter. I'm just trying to drive that, the behavior of advertising gross margins in second quarter and going forward.

[Chinese] So Mark, with regard to your second questions on the advertisings business, on the content procurement costs or the headcount-related costs. Of course, for this year, especially, in the first quarter, there has been some pressure to it because you would also foresee that we have also introduced some new content on the -- such as the online video content, which the costs would be a bit higher. But if you take to look at the fact that usually, the first quarter will be the low seasons for us the whole year, and we do see that going forward to the second quarters and the rest of this year. The situation would be progressively improved, and we do see that there would be some enhancement in terms of the gross margins for the advertising business in the upcoming quarters.

And then just one housekeeping item. On the tax rate, you talked about the tax holiday expiring in Q4 for some subsidiaries. How should we model taxes going forward, given the situation you described?

So basically, on an annualized basis, I would suggest you to take about 15% as the tax rate for the whole year.

And our next question comes from the line of Doug Creutz, Cowen & Company.

I wondered conceptually, I think we've seen in the United States, that there's been somewhat of a shift from PC gaming on to mobile devices. And I'm wondering what you think about the potential churn in China, how you think you want to address that, do you think it's a threat to your business, or an opportunity and just sort of how you're thinking about that?

[Chinese]

[Chinese] [Technical Difficulty]

Okay. So [Chinese]

So basically, with regard to Doug's questions on the overall change in the Internet markets from the PC platforms to the mobile platforms, we believe that this is a positive things to happen. And in fact, such change is also, cannot be escaped or cannot be avoided. And we also note that currently, the mobile handset market has been very competitive, given the fact that the costs of the mobile handset is going down every now and then, and that's the mobile handset, say for example the smartphone, is getting its popularity more and more in the China market. And so this is definitely a new trend that we have seen and take note of. And so far for NetEase, we do have a quite a lot of very popular and useful applications in this area to facilitate users to use such functions on their mobile handsets, such as the Youdao Dictionary, the Youdao Note, and many others. And in fact, in this morning, William has also read a news, which is very encouraging, because the Apple apps has also ranked our Youdao Dictionary as the editor's choice of applications, which is a very good things to know about. And going forward, we do want to make a -- another step forward by putting our cloud service -- to make good use of the cloud technologies to roll forward our mobile applications to the various users using the mobile handsets and things like that. And on the other note, with regards to the online gaming developments or the change in the trend from the PC to the mobile platforms, I think that this is one of the very important topics that we are currently, seriously, are thinking about and considering.

And we have no further questions. Management, you may continue.

Thank you once again for joining us today. Please feel free to contact NetEase's Investor Relations Manager, Cassia Curran, or the company's IR firm if you have further questions. Have a great day. Thank you.

Ladies and gentlemen, that does conclude the NetEase, Inc. First Quarter 2012 Earnings Conference Call. If you like to listen to today's replay, the phone number is 1 (800) 406-7325, access ID 4533318. Thank you, and have a good day.