NetEase, Inc. (NTES) Q2 2012 Earnings Report, Transcript and Summary

Good evening, ladies and gentlemen and thank you for standing by. Welcome to the NetEase, Inc. Second Quarter 2012 Earnings Call. [Operator Instructions] This conference is being recorded today, August 15, 2012. I'd like to turn the conference over to Ms. Brandi Piacente. Please go ahead.

Thank you, operator. Please note that the discussion today will contain forward-looking statements relating to future performance of the company and are intended to qualify for the Safe Harbor 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 ir.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. West [ph] builds our reputation on introducing innovative product and services that shape China's Internet market. Through this standard of excellence, we can both satisfy user demand and further elevate China's Internet content with our benchmark offerings, this continues to drive loyalty and appeal within our growing community. For the second quarter of 2012, our total revenues increased 12.7% year-over-year, with online games growing by 10.8% and advertising services increasing by 20.4%. Our self-developed games continue to drive our growth capturing the attentions of new users and increasing playtime within our existing community of game enthusiasts. Standout performances in the quarter came from our self-developed titles, including Ghost, which achieved record revenue in May, Fantasy Westward Journey and Tianxia III. The long-term success of our self-developed games is driven not only by the top-quality user experience and innovative game play we offer, but also by the introductions of new features and the expansions of game life cycles through the introductions of new content via the launch of the expansion packs, as well as the integrations of user feedback. This strategy prolongs the enjoyment of our current users and attracts new players to our diverse collections of games. The second quarter was filled with activities to stimulate user demand, and during the period, we launched open beta testing for Ghost and Tianxia III as well as introduced new content, both Fantasy Westward Journey. We also launched new expansion pack for Warsong of Westward Journey, Heroes of Tang Dynasty, and Westward Journey Online II. And we expect the impact of these expansion packs to be reflected in the coming quarters as the market absorbs these new adventures. We expect other activities in the second half of the year for our self-developed games to include the launch of new expansion packs for Fantasy Westward Journey, Tianxia III, Ghost and Westward Journey Online III. Our research and development team has been diligently working on new additions to our portfolio of games. The first 2 of these games, Wu Hun, which we have renamed Kung Fu Master and Soul of Warrior, which we have renamed Soul of the Fighter, are designed to address users increasing appetite for action games and further diversify our portfolio. In July, we launched initial closed beta testing for these 2 games, and while it is still early in the testing process, initial feedback has been encouraging. We are currently preparing to commercially launch both games in the second half of the year. In addition, our next-generation 3D MMORPG, Dragon Sword and 3D action real-time strategy game, Heroes of Three Kingdoms, are being developed to the highest standards of quality, and we will be performing technical tests this year to obtain user feedback on those games. In conjunction with the launch of our new games and expansion packs, we plan to conduct our usual large-scale promotional activities. Our marketing schedule currently calls for hosting summer vacation promotions for Fantasy Westward Journey, as well as celebrating the 10th anniversary of Westward Journey Online II and conducting promotional campaign to market our 2 new games. Turning to our portal activities, mobile assets is a growing theme among China's Internet users, and we are keenly aware of the importance of offering relevant advertisings and portal services that appeal to an increasing mobile society as well as traditional Internet users. During the second quarter, we continue to attract new advertising customers through content innovations, new product development and service integrations among mobile platform. As a result, second quarter revenues from our advertising services grew 42.3% quarter-over-quarter. With automobile, fast-moving consumer groups and financial services, set as coming in as the top-performing verticals. High profile sporting events has also been a recent focus among our advertising services. In particular, Euro Cup 2012 and the London Olympics have presented globally-recognized events, in which we have been fortunate to finance in our services as secure advertising customers. In the second quarter, we were pleased to secure a strategic partnership with China Network Television to broadcast the most recognizable sporting events worldwide. The London Olympic Games, with key events and opening and closing ceremonies broadcast on our portal as well as our top ranking mobile news application. For our portal and e-mail business, we continue to introduce new attractive content, with increased mobile assets. In the second quarter, the registered number of users for our micro-blogging service increased by 48.8% sequentially to 180 million. Mailbox services also increased to 495 million registered users as of June 30, 2012. We continue to advance both services by introducing new content and enhancing the user experience to broaden our existing community. Across our 3 core businesses, online games, portal and search, we believe in differentiating our platforms by providing a premium user experience with a focus on quality, integrity and ingenuity. Each of our products and services displays this concept and we look forward to expanding and diversifying our offerings to which customers demand for new content with a robust pipeline of games and activities planned for the second half of the year. This concludes William's update. Now I will provide a review of our second quarter 2012 financial results. I will primarily focus on the discussions of margins and expense fluctuations, along with net profit. Gross profit for the second quarter of 2012 was RMB 1.3 billion or USD $208 million. This compares to RMB 1.3 billion and RMB 1.2 billion for the preceding quarter and the second quarter of 2011, respectively. The year-over-year increase in gross profit was primarily attributable to increased revenue contributions from our self-developed games: Ghost, Fantasy Westward Journey, and Tianxia III, which was partially offset by a decline in revenue from Blizzard Entertainment's World of Warcraft. Gross profit margin for our Online Game business was 73.3% compared to 73% and 70.2% for the preceding quarter and the second quarter of 2011, respectively. Gross profit margins for our advertising business was 33% compared to 19.8% and 43.9% for the preceding quarter and in the second quarter of 2011, respectively. The quarter-over-quarter increase in gross profit margin was primarily due to an increase in advertising services revenue. The year-over-year decrease in gross profit margins was primarily due to increased headcount related costs and video content costs incurred in the second quarter of 2012. Gross loss margins for our e-mail, WVAS and others business was 11.6% compared to 18% and 7.8% for the preceding quarter and the second quarter of 2011, respectively. The quarter-over-quarter change was mainly due to improved performance from our e-commerce business in the second quarter of 2012. Total operating expenses were RMB 437.7 million or USD $68.9 million, compared to RMB 355.7 million and RMB 365.8 million for the preceding quarter and the second quarter of 2011, respectively. The quarter-over-quarter increase in operating expenses was mainly due to increased selling and marketing promotional activities related to the open beta testing of Ghost and Tianxia III in the second quarter of 2012, as well as increased research and development expenses related to product development. The year-over-year increase in operating expenses was primarily due to increased headcount-related costs, which was included in general and administrative and research and development expenses. Net profit for the second quarter of 2012 totaled RMB 875.3 million or USD $137.8 million, compared to RMB 941.7 million and RMB 772.5 million for the preceding quarter and the second quarter of 2011, respectively. During the second quarters of 2012, we reported a net foreign exchange loss of RMB 36 million or USD $5.7 million, compared to a net foreign exchange gain of RMB 17.6 million and a net foreign exchange loss of RMB 3 million for the preceding quarter and the second quarters of 2011, respectively. The quarter-over-quarter and year-over-year changes in foreign exchange gains and losses were mainly due to the translations gains and losses arising from the company's euro-denominated bank deposit balances as of June 30, 2012, as the exchange rate of the euro against the RMB fluctuated over the period. We reported basic and diluted earnings per ADS of USD $1.05, each for the second quarters of 2012. This compares with basic and diluted earnings per ADS of USD $1.13 each for the preceding quarter and basic and diluted earnings per ADS of USD $0.93, each for the second quarters of 2011. We recorded a net income tax charge of RMB 149.5 million or USD $23.5 million for the second quarters of 2012 compared to RMB 153.1 million and RMB 92.4 million for the preceding quarter and the second quarters of 2011, respectively. The effective tax rate for the second quarters of 2012 was 14.8% compared to 14.9% and 10.9% for the preceding quarter and the second quarters of 2011, respectively. Our various principal subsidiaries renewed their qualifications as High and New Technology Enterprises in 2011 and therefore, enjoyed a preferential enterprise income tax rate of 15% from 2011 to 2013, subject to annual review by the relevant tax authorities in China. The year-over-year increase in effective tax rate was mainly due to the expiration of the enterprise income tax exemption period for certain subsidiaries that were qualified as Software Enterprises, which resulted in an increase in the applicable tax rate from 0% to 12.5%. As of June 30, 2012, our total cash and time deposits balance was RMB 13.8 billion or USD $2.2 billion compared to RMB 11.9 billion as of December 31, 2011. Cash flow generated from operating activities was RMB 880.9 million or USD $138.7 million for the second quarters of 2012 compared to RMB 1.3 billion and RMB 995 million for the preceding quarter and the second quarters 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 about World of Warcraft, maybe can you talk about the reasons for the revenue decline in the second quarter? Was it because gamers were waiting for the new expansion pack and delayed increased spending? Has the revenues stabilized in first quarter as we've seen so far?

[Chinese]

[Chinese]

So basically, with regard to the questions that's brought up by Timothy just now with regard to the new expansion packs for World of Warcraft, we are still in the preparation phase for it. And today is the 16th of August, and in fact, we would hold a media events and activities to share our new ideas and content for this new game. And we also believe that with the introductions of those new contents and features of the new expansion packs, the potential impact to the markets would be quite positive though.

Could you maybe also quickly talk about the progress of Diablo III?

[Chinese]

[Chinese]

So basically, with regard to the progress of Diablo III, basically, we are actively working together with the British Bank [ph] in preparing for it, and we would give you more update as we -- as it comes to a more appropriate timing.

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

I have 2 questions. The first question is related to our research and development expense, as we've seen that the expected growth varies back in your recent quarters. Could William comment on the trend and on the strategy related to this expense for -- with NetEase? [Chinese]

[Chinese]

So basically, for our R&D spending strategy, basically our view is that we would like to retain and hire the talented people for us to cope with the company's ongoing experiments and expansion. And we also believe that by doing so, we would be able to maintain our competitiveness in the market as compared to without.

And then my second question is as several of our competitors that were leading the micro client version of their major games, does NetEase have any plans following this trend, and how does William think of another trending decline games that went to the cloud gaming? [Chinese]

[Chinese]

The question is more about your comments on the whole trend of cloud gaming. Just... [Chinese]

[Chinese]

Martin, let's pause there for a second, so we can have the translation.

I think William has just touched on quite a lot of areas regarding questions about the micro client end games and the cloud games and such. And basically, I think for the client-end games, basically there is not much difference from the way that the current client-based game is currently operating. The only exception is that with regard to the download times, maybe there will be a squeeze from 2 hours to 30 minutes each time for doing so. But with regard to the core competitiveness of all games, I think it will still be getting down to the gameplay and the content that we offer in the market that is more important. And with regard to the cloud games of interest, I think basically there is not much from what we have already doing for now. The only things that may come up would be on the basis that we are going to give the database for facilitating some of games making use of the cloud technologies. And with regard -- regarding the trend of the cloud gaming developments, I think it's still not a questions of whether it is a cloud or not, but whether it is a good game titles that are going to roll out to the market, because in the end, we believe that for some good quality games that we'd be able to roll out to the market, then the people would have a better experience as such. And the overall strategies for NetEase in the gaming front is that, for whatever categories of games that we are going to launch in the market, we would go for the highest qualities and the premium content that we are going to offer in the market. And we also try our best to make sure that we would perform in the market with the #1 and #2 place, as such.

Our next question comes from the line of Mark Marostica with Piper Jaffray.

I wanted to get a little more color on your games marketing schedule in the second half of the year. I know you have a lot of activity around second half expansion pack launches and 2 new game launches. Will we see more of the marketing effort concentrated in Q3 or in Q4?

[Chinese]

[Chinese]

[Chinese] Basically, Mark, with regard to your questions about our views on how we are going to rollout the new games in the second half of the year, basically, we would cast [ph] some new games coming up in the second half of 2012 touching on the ARPG genres. But other than the action RPG games that we are going to roll out in the market, William would also like to highlight that we should not only focus on the new games that we're going to rollout, but can also take the load on some of our older games of course, that has been operating in the markets for a few years like the Fantasy Westward Journey in the past quarters. In fact, it has also come with a very encouraging PCU numbers of 2.17 million people at one time, which is very encouraging. And from there, it also reinforced our visions that the good qualities games with the right content could actually drop a very good response in the market.

Our next question comes from the line of Jin Kyu Yoon with Nomura.

This is Ruby [ph] for Jin Yoon. I just -- 2 quick questions. One is, if you could elaborate on your -- the margins for your self-developed games, kind of where that's trending. And secondly, a housekeeping question, where do you expect your margins to be in the next 2 quarters?

So basically with regard to our margins for our games, because we would agree with comprehensively by taking both the self-developed games and also the licensed games together. So you would see basically from our press release that we also done a separate disclosures in the segment information where the composite margins would be somewhere around 73% and in fact, for the second quarter, there has been a mild increase to 73.3%. And actually, if you look back in the back -- early years when we first operating with just our self-developed games, the margins would be much higher. But in the near term, we still believe that this will be the kind of margins that we'll be looking at.

Our next question comes from the line of Atul Bagga with Lazard Capital.

I have 2 questions for you. Number one, on second quarter, when you look at the sequential decline in online gaming revenue, I mean, is it all coming from World Warcraft or is any of them in-house game? Also, you saw any weakness, what is your expectation? And the second question is regard to your reboot service, I mean, micro-blogging service. You saw pretty nice growth in second quarter in terms of the user number, what is driving that, A, and B, what's the plan? How do you monetize that user base?

[Chinese]

[Chinese]

So basically, maybe I'll just get back to you on your second question. First, regarding our growth in the registered users for the micro-blogging services. Basically, NetEase got a wide array of products and services projecting to the new users in the market in general. And we believe that those different kind of services like the e-mail, the games, the news application and also our Youdao dictionary, kind of services would effectively attract the users in the market, and in such a way also helps out to the increase in our registered users in terms of our micro-blog services as well. And we always believe that the quality of our product and services, as well as the enhanced and user-friendly features that we are offering to the users would be well-positioned to attract a very good group of users using our products and services in general. And on the other hand, we have also do some very effective marketing events and activities in order to boost the usage of our products and services in general. And we also try to do some cross marketing strategy in order to make our overall business through developing a more well managed. And this will basically, the responses for the -- for your second question. And with regard to your first question about your decline in revenues in the second quarters of 2012, basically, you're quite right that the decline would be mainly attributed from the declines in the World of Warcraft performance. And at the same time, I would also like to bring up to the fact potentially in terms of the seasonality for the online gaming business, the second quarters would also be somehow being soft quarters owing to the service that in China markets, there would be the expensive months, whereas the lower-aged players will spend less the time in playing the games. But in general terms, in lieu of performance of our online gaming business for the second quarters, I think it is still quite in line with our expectation.

Our next question comes from the line of Wallace Cheung with Crédit Suisse. Wallace Cheung - Crédit Suisse AG, Research Division: [Chinese] So basically, I have 2 questions. One, I just wanted to get more color on the corporate e-mail services, and second is on your sense of strategies.

[Chinese]

So basically, with regard to Wallace's questions, the first one about the e-mail, I think, basically, NetEase is very focused on our e-mail business development. And for this year, this will be our 15 years in the business so far. And in the past 10 years, over the past 10 years, we have been ranked at #1 in the free e-mail service market. And we always believed we have an absolute leading position in the free e-mail services, and at the same time, other than the free e-mail services that we are offering in the market, we also have other pedigree of services called the VIP mailbox, where we have also patented some enhanced features to facilitate the usage of our users like the e-fax functions, where it would be very user-friendly and convenient for the users to get fax and/or to send from there. And although, the total user numbers in terms of the web e-mail box is not where we think for now, but we do see that, it has got a very good way for the further growing in this sense. And we always believe that we do have a very good qualities and best of its kind in terms of the communications kind of products and services offering in general. And with regard to Wallace's second questions with regard on the mobile Internet kind of stuff, basically, I think for now, NetEase do got quite a diverse array of applications in place, like the mobile dictionaries, where lately installations number has surpassed 100 million already. And also, we have our own mobile news app, where it would be very easy and convenient for the people to grab the latest news especially for the recent Olympic games as such. And from the strengthening point of news, I think basically we would be marketing towards free areas like the informations, the utilities or the working [indiscernible] in terms of stock and also the educations. And from there, you would see that for NetEase, for now, we have quite a lot of applications from there. Like the NetEase mobile news apps and also the Youdao Dictionary, our cloud notes and our cloud readings and things like that. And in terms of the educations, we have our open educations applications as well. And going forward, we do see that there has been a trend in terms of the developments for the mobile Internet, and we do see that there would be somehow, some changes in the way that people would be socializing, getting informations during communication and such. And we would put a few emphasis and focus for developing in this area.

Our next question comes from the line from William Huang with Barclays.

I have 2 questions. My first question is about advertising. So what is the outlook for second half advertising environment? Is there any difference NetEase is seeing or experiencing the overall ads demand versus other peers given that most other companies guided a bit softer outlook?

So I think basically, with regards to the outlook for our advertising business in the second half of this year, we are in active communications with our advertisers and have solid working relationships with these customers. And we think the cooperators with, again, with customers in the second quarters [indiscernible] for the coming period. While we do not provide any guidance in this area, we are still cautiously optimistic back to our impact in this business growth in the second half of the year, which takes into accounts the system about novelty issues and also the impact of the London Olympics.

Okay. I have a follow-up question about the gaming business. Can you update the performance, the latest performance of your newly launched game titles such as Wu Hun, Heroes of Three Kingdoms, given that more competitive landscape, how should we expect the user traffic and monetization potential the next few quarters?

[Chinese]

[Chinese]

Okay. Basically, with regard to the general performance of our games in the newly launched games in the market, I think what market the new games that net user going to launch in the market, we would be very serious about that. And also to a very detailed analysis to see where our particular game titles would fit in the market expectations, both in terms of the game contents, the gameplay, the features and things like that. And if we got a very positive response about the basic fundamentals of those games that we're going to rollout in the market, then we will be then taking the next step by rolling the games out to the market. And so far, other than that one that you just mentioned just now, which in English called the Soul of the Fighter, the other games that we also feel like to share with you, would be the Wu Hun or now named as the Kung Fu Master. Those games, although still in the early stage of the rollout in the market, but the feedback from both games has been also very positive and quite in line with the company expectation. And along this line, this will be what we are currently doing for those newly-launched games and for the upcoming games that we have shared earlier in these calls, like the Dragon Sword and also Heroes of Three Kingdoms, those will be our other new initiatives that we're going to put through to the market in the upcoming period.

Our next question comes from the line of Doug Creutz with Cowen and Company.

It seems like Warcraft has been a bit of a drag in your overall results for a couple of quarters now, and I just wondered if you could give some perspective? And it is a game that's been in the Chinese market for several years, but we have other games including some of your own that has been in the Chinese market for longer and yet have managed to continue to grow. Maybe you could offer us some perspective in why you think Warcraft is struggling to retain its user base now compared to some of your other titles?

Okay. Thank you. [Chinese]

[Chinese]

By answering to the questions you're asking, performance of the WoW. First of all, I think it would be better for us to share some of our experiences of operating one of our legendary game titles called the Fantasy Westward Journey. This game, in this game's history, has been operating for quite a long time. And even that the game has been operating for over 8 years, it still would be able to get some new users to play this game and also make some new records of revenues as well. And as such, our experiences of doing so is that for good game titles with a very experienced R&D teams who would actually do some into understand the actual use in the market. And then to couple that and ongoing enhancement in terms of the game contents and features, then we believe this would lace a very good grasp for the game titles these steps for a grown. And coming back to World Warcraft, this is one of the games that we licensed from the Blizzard Entertainment. And we always view that Blizzard Entertainment is a great game operator as such. And we have confidence in the game titles for -- especially for the World Warcraft. And although there has been some drag in terms of the performance for the past few -- or the past couples of quarters, we still believe that this -- with the upcoming launch of the new expansion pack, which is the Mists of Pandaria, where this would get some new titles, new content in there, we do look forward whether this would make some new hits to the market in the upcoming periods. And as always, we believe that for some good content and good qualities games is worth have a very good potentials for the growth in the sales.

[Chinese]

So there is another highlight or supplement that William would like to share of you with regard to the expansion packs, the Mists of Pandaria that's due to launch soon in the China market. One of the very unique and special features for this new expansion packs is that it has embedded quite a lot of Chinese elements or -- in the expansion pack itself. And so from there, you would appreciate that the business to actually put a very serious episodes about the user experiences or the -- across the users in the China market. And we do look forward that with all these new things coming up to the China market, there would be a new spring -- bring to game titles itself.

Thank you. Due to time restriction, our last question comes from the line of Thomas Chong with BOCI.

I have only one question. Can management provide some color on the top 5 games this quarter?

So basically, without giving you any ranking in terms of our games, I think our top-performing games or the major revenue contributing games would include the Fantasy Westward Journey, Westward Journey Online II, the Tianxia, Ghost, Heroes of Tang Dynasty, and also the World of Warcraft.

Thank you. I'd like to turn it back over to management.

Thank you, everyone, for joining us today. Please feel free to contact the current investor relations manager for NetEase or The Piacente Group if you have further questions. Have a great day.

Ladies and gentlemen, that does conclude the NetEase, Inc. Second Quarter 2012 Earnings Conference Call. If you would like to listen to today's replay, the phone number is 1 (800) 406-7325, access ID 4556534. Thank you for your participation. You may now disconnect.