NetEase, Inc. (NTES) Q1 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the NetEase, Inc. First Quarter 2013 Earnings Conference Call. [Operator Instructions] This conference is being recorded today. And I would now like to turn the conference over to Brandi Piacente. Please go ahead.

Thank you, operator. Please note that discussions today will contain forward-looking statements relating to future performance of the company that 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 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 replay -- webcast replay of this conference call will be available on the NetEase corporate website at ir.netease.com. I will now turn the call over to Mr. Onward Choi, Acting Chief Financial Officer, who will read the prepared remarks on behalf of Mr. William Ding, Chief Executive Officer of NetEase.

Thank you, Brandi. Before I begin, please note that for the purposes of this discussion, all percentages are based on renminbi. We are pleased with our first quarter results, as we continue to improve our distinctive portfolio of online services that appeal to a broad community across China's dynamic Internet markets. Our revenues for the first quarter reflect year-over-year growth across our 3 business segments, with total revenues increasing 12.7%, driven by our self-developed online games. Our total online game revenues increased at 11.3%, and our advertising services business improved by 15.3%. During the quarter, we saw healthy growth across our principal self-developed games, which were partially offset by decrease of revenues from our licensed games. The increase in online games revenues was driven by Fantasy Westward Journey and Westward Journey Online II, which we introduced price increases for in February of this year, as well as the performance from Heroes of Tang Dynasty II and Kung Fu Master, 2 of our newer games that have been met with positive reception. The price increases that we implemented occurred after the 10 years of never having raised our prices for this game and our users have remained loyal. We also introduced a series of promotional packages that were designed for users to experience this move and placed in transition to the new pricing. Lastly, I'd like to mention that Tianxia III and Ghost performed well during the first quarter, following our recent promotional activities for these games. Our activities during the first quarter include launching a new expansion pack for our new Fly for Fun in mid-January and initiating large-scale marketing activities for Kung Fu Master at the end of March. We expect these marketing efforts will support the games' growth in the second quarter. For the second quarter, we have a robust release schedule in process with new game introductions that diversify our channels and expansion packs and are designed to extend the life cycle of our games. We have already begun these activities with the commercialization on April 10th for Heroes of Three Kingdoms, our 3D realtime strategy game which has performed well in the early stages of its launch. We have also introduced expansion packs for Westward Journey Online II and Westward Journey Online III. In addition, at the end of April, we released Ghost II, a comprehensive upgrade of Ghost, which we launched in September of 2011. We believe these new versions will build on the successful platforms of the original games. We are pleased with the initial performances of these games, and user feedback has been positive. In the coming months, we plan to introduce expansion packs for Warsong of Westward Journey and Tianxia III, as well as continue Fantasy Westward Journey's 10 years' record of success by introducing a comprehensive upgrade. We are on track to continue to broaden our portfolio this year. In the second half of 2013, we plan to introduce Dragon Sword, our next-generation 3D MMORPG; and Legend of Tibet, a 2.5D MMORPG that follows a unique story based on Tibetan mythology, followed by a first-person shooter game. Lastly, our current release schedule includes new expansion packs for Kung Fu Master, Soul of the Fighter and New Fly for Fun. In the future, we may also carefully consider and explore the opportunities of introducing our popular online games, such as Ghost II, to overseas markets and intend to consider our existing business partners when selecting our licensees. To complement our online game offerings, we are also leveraging over a decade of experience as an innovator and pioneer of online games and services to enter the mobile gaming space. Our brand currently calls for the introductions of several mobile games this year, and we will provide more detail as we get closer to launching these games. We see these as a natural extensions of our expertise and opportunities to expand our broadened platforms of games to the widely untapped mobile games market. In addition to our online games, during the first quarter, we grew our advertising services revenues year-over-year. Automobile, fast-moving consumer groups and financial services were the top-performing sectors. By providing users with high-quality and high-demand content, we believe we have a competitive edge to advance our leadership positions for our portal mobile applications and email services. We are attracting new users to each of these areas and expanding our reach within our community. As of March 31, 2013, we have more than 550 million email users, and there were 75 million installations of our industry-leading mobile games applications with 29 million daily active users. Youdao Dictionary also continued to increase in popularity. And by the end of the first quarter, we have 300 million cumulative users, with over 50 million monthly active users. At the end of April, we launched NetEase Cloud Music, an SNS application that gives musicians and music fans the ability to discover and share music. This is just one example of the ways in which we continue to introduce new and exciting applications to further cultivate a rapidly growing audience of traditional and mobile Internet users. I am also pleased to announce that following our special cash dividend, there was issue in January of this year. Our Board of Directors has approved the distributions of an annual dividend beginning this year. We have been afforded ample financial flexibilities, and we are delighted to extend these additional returns to our loyal investors. As we move through 2013, our focus will be to build on our platform of popular online games, expand our community and grow our advertising services. We will also look at new trends that leverage our strong R&D capabilities to enhance our offerings and support the continued growth of our business. This concludes William's updates. Now I will provide a review of our 2013 first quarter financial results. I will primarily focus on the discussions of margins and expense fluctuations along with net profits. Total sales tax for the first quarter of 2013 were RMB 105.4 million or USD 17 million compared to RMB 55.8 million and RMB 38.5 million for the preceding quarter and the first quarter of 2012, respectively. The increase in sales tax was mainly due to a change in the tax rules in China, which resulted in our online game revenues becoming subject to value-added tax instead of business tax. 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, this change in the tax rules in China did not have a significant impact on gross profit of our online game services business segment. As a result, the increase in gross profit margin was attributable to the lower net revenue due to the increased value-added tax in sales taxes. Gross profit for the first quarter of 2013 was RMB 1.5 billion or USD 248.9 million. This compares to RMB 1.6 billion and RMB 1.3 billion for the preceding quarter and the first quarter of 2012, respectively. This quarter-over-quarter decrease in gross profit was primarily attributable to a seasonal decline in advertising services revenue. The year-over-year increase in gross profit was primarily attributable to increased revenues from the company's self-developed games: Fantasy Westward Journey, Westward Journey Online II, Kung Fu Master, Heroes of Tang Dynasty II and Ghost, which were partially offset by a decline in revenue from Blizzard Entertainment's World of Warcraft. The revenue increases from Fantasy Westward Journey and Westward Journey Online II were mainly due to the increasing appeal of these games to users resulting from enhanced game qualities and the contributions from an increase in unit price from -- for playing time for these games, which was implemented in February 2013. Heroes of Tang Dynasty II, the comprehensive upgrade of Heroes of Tang Dynasty, performed well since its launch in November '12. Kung Fu Master, one of NetEase's newest games launched in 2012, performed steadily during the first quarter with encouraging feedback from users after several major marketing promotional activities that were initiated in March 2013. The decrease in revenue from World of Warcraft was mainly due to its reduced user consumption. Gross profit margin for our Online Game business for the first quarter of 2013 was 77.8% compared to 75.3% and 73% for the preceding quarter and the first quarter of 2012, respectively. Gross profit margin for the Advertising business for the first quarter of 2013 was 29% compared to 54.3% and 19.8% for the preceding quarter and the first quarter of 2012, respectively. The quarter-over-quarter decrease in gross profit margin was primarily due to a seasonal decline in advertising services revenue. The year-over-year increase in gross profit margin was primarily due to increased advertising revenues in the first quarter of 2013. Gross loss margin for the email, WVAS and others business for the first quarter of 2013 was 13.1%, compared to gross profit margins of 13% and gross loss margin of 18% for the preceding quarter and the first quarter of 2012, respectively. The quarter-over-quarter change was mainly due to decrease in revenue from sales of game-related accessories in the first quarter of 2013. Total operating expenses for the first quarter of 2013 were RMB 455.6 million or USD 73.4 million, compared to RMB 580.4 million and RMB 355.7 million for the preceding quarter and the first quarter of 2012, respectively. The quarter-over-quarter decrease in operating expenses was mainly due to reduced selling and marketing promotional activities in the first quarter of 2013, mainly resulting from reduced promotional activities for World of Warcraft, Heroes of Tang Dynasty II and Tianxia III. The year-over-year increase in operating expenses was primarily due to increased headcount-related costs in research and development expenses and increased promotional costs for our self-developed games. We recorded a net income tax charge of RMB 142.9 million or USD 23 million for the first quarter of 2013, compared with RMB 184.2 million and RMB 163.1 million for the preceding quarter and the first quarter of 2012, respectively. The effective tax rate for the first quarter of 2013 was 11.8%, compared to a 15.4% and 14.9% for the preceding quarter and the first quarter of 2012, respectively. During the first quarter of 2013, we reported a net foreign exchange loss of RMB 9.3 million or USD 1.5 million, compared to a net foreign exchange loss of RMB 5.8 million and a net foreign exchange gain of RMB 17.6 million for the preceding quarter and the first quarter of 2012, respectively. The quarter-over-quarter and year-over-year changes in foreign exchange gains and losses were mainly due to the unrealized exchange gains and losses arising from our foreign currency-denominated bank deposit balances as of March 31, 2013, as the exchange rate of the euro against the RMB fluctuated over the period. Net profit for the first quarter of 2013 totaled RMB 1.1 billion or USD 171.2 million, compared to RMB 1 billion and RMB 941.7 million for the preceding quarter and the first quarter of 2012, respectively. We reported basic and diluted earnings per ADS of USD 1.32 each for the first quarter of 2013. This compares with basic and diluted earnings per ADS of USD 1.24 for the preceding quarter and basic and diluted earnings per ADS of USD 1.16 and USD 1.15, respectively, for the first quarter of 2012. As of March 31, 2013, our total cash, time deposits and short-term investments were RMB 16.4 billion or USD 2.6 billion, compared to RMB 16.3 billion as of December 31, 2012. Cash flow generated from operating activities were RMB 1.5 billion or USD 249.2 million for the first quarter of 2013, compared to RMB 1.3 billion for each of the preceding quarter and the first 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 tax authorities in China. In addition, certain of our subsidiaries were recognized as Key Software Enterprises in March 2013 and enjoyed a further reduced preferential tax rate of 10% for 2011 and 2012, with the resulting tax benefits of RMB 304.6 million recorded in the financial statement for the first quarter of 2013. The aforementioned tax benefits were partially offset by the recognition of withholding income tax accrual of RMB 263.5 million in connection with our plan to distribute a portion of our earnings of certain of our PRC subsidiaries to their offshore parent companies in order to fund our business operations and the annual dividend policy approved by our Board of Directors. Under this policy, we intend to make annual cash dividend distributions commencing in 2013 in an amount between 20% and 25% of our anticipated annual net income after tax in the current fiscal year. The determination to make dividend distributions and the amount of such distributions in any particular year will be made at the discretion of our Board of Directors and will be based upon our operations and earnings, cash flow, financial condition, capital and other reserve requirements and surplus and any applicable contractual restrictions, the ability of our PRC subsidiaries to make distributions to their offshore parent companies and any other conditions or factors which the board deems relevant and having regard to the directors' fiduciary duties. Finally, before we open the call to your questions, I would like to provide an update on the special cash dividend and share repurchase program, both of which were authorized by our Board of Directors in November 2012. The special cash dividend of USD 0.04 per ordinary share, which is equivalent to USD 1 per ADS, amounted to approximately USD 131 million and was paid to shareholders of record as of January 15, 2013. Under our USD 100 million share repurchase program as of March 31, 2013, we have cumulatively purchased approximately 2.02 million ADS in the open market for a total consideration of approximately USD 83 million. The share repurchase program expires on November 20, 2013. Thank you for your attention. We will now be happy to take your questions. Operator, please go ahead.

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

I have 2 questions. The first question is, could you maybe comment a little bit more of your new game pipeline, especially the titles like Dragon Sword, League of Legends and also the existing games? What do you think the potential of these titles are? And how are they different from the existing titles that you are operating? [Chinese]

[Chinese]

Okay. So basically, to recap on the new game pipeline of the company, I think going forward, we will be rolling out quite a number of new game titles to the market, which would be in the -- in form of the game types would be quite different from what we are currently or existing operating. And first of all, like the -- we would be focusing more game types on the competition type of games and the one that we are going to launch would be the Heroes of Three Kingdoms, which, we believe, would also fuel up this space. And we would also try to develop some other types of games that would be to -- designed to tap into the different niche and the features in the game market in general. And going forward, we would also roll out some new mobile games in the market. And some of those would be an extension of our -- the existing PC games, and some of those would be some especially designed games that would be played on the mobile platforms.

My second question is on your mobile games development. Obviously, NetEase has a lot of mobile users on services like news app and also cloud notes. May I ask, would you also consider launching some of maybe the mobile game platform leveraging the success of your mobile apps. [Chinese]

[Chinese]

Yes. So basically, with regard to the company's strategies on the mobile games developments, basically, we would focus both on the platform development and also the product developments.

[Chinese]

And in the upcoming next month, hopefully, you would see something about our mobile game platforms and also some games -- mobile games in the market.

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

I have 2 questions. The first one is about licensing games. So just wondering how you could -- how you would look at the prospect of World of Warcraft, given a pretty big sequential decline in the first quarter supposedly. And then just secondly, you mentioned about some new trends that you will focus on. What could be some of those new trends? We have seen some quite M&As in the Internet space recently. NetEase has been growing organically in the past, like a decade or so. So will the company consider using acquisitions as part of the strategic tools to get into some of these new trends?

[Chinese]

[Chinese]

So first of all, with regard to Eddie's questions on the licensing games and the company's will to it, basically, we are licensing not only the World of Warcraft but we are also licensing the StarCraft II. And we believe that those 2 game titles are of very good qualities, and we feel happy that we got a very good business partners as such, like Blizzard Entertainment. And with regard to our will on the new trends or the potential acquisitions, investments or mergers and things like that, basically, NetEase would uphold a very open attitude to asset, and we would be very open to enter into potential acquisitions, investments or mergers and things like that as we see fit, especially when those targets can fit in to the company's business developments or can create some strategic values to the whole group.

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

I have one question. I remember William mentioned over the past -- over the last conference call that doing mobile games is relatively easy compared to [indiscernible] games and that maybe it had found a good way to do mobile games. Now that 3 months have passed, just wondering if you are still the same confident or even more confident about your -- about the prospect of your mobile games. And also can you give us an update on your mobile game initiatives so far into the year? [Chinese]

[Chinese]

So basically, with regard to our progress in terms of the mobile games development, I think the company is still fairly quite positive to it, and the progress so far has been smooth. And we also got the confidence that, in the long term, we would create some positive results in terms of this new business development. And we also hold a positive will across the long-term development in this business sector.

And our next question comes from the line of Tian Hou from T.H. Capital.

This is Gina calling in for Tian. My first question is for NetEase, as a game developer, developing mobile games shouldn't be an issue but the success of a game is dependent on the mobile distribution. Can you give us your thoughts on your mobile distribution channel strategy?

[Chinese]

[Chinese]

So basically, with regard to the company's strategies in terms of the mobile games' distribution, in a word, we would take a very diversified approach in achieving this aim. First of all, we believe that we got a very good products settings because you would see that in terms of our mobile news applications, we have a very high numbers of installations and we also got some other types of new mobile applications like the EaseRead and also some other dictionaries and cloud notes and things like that, which means that we have a very wide array of mobile applications in place already, which we also believe would set out a very good growth for cross-selling capabilities of our upcoming mobile games or other stuff like that. And secondly, we also got a very strong email platform and also news platform, which we believe we'll be able to get reach to our targeted consumers or the users of the potential mobile games applications. And thirdly, we would also make good use of doing some pre-installations of those applications on certain handsets in order to enable a much wider and extensive distributions of our mobile games. And having said that, we believe that we already got a very solid foundation in distributing the products and services alike for NetEase. And say, for example, we are very -- we got a very good performance or the stand in the PC games development, and we also foresee and believe that the people could make good use of the fragmented times by experiencing the mobile games as well and somehow, we would also make some efforts say, for example, by extending certain game play from our existing PC games to the mobile platforms, so that people can experience different kinds of things on different devices or different platforms. And in the end, we do feel that this is just a matter of how the people would be making good use of their time, both their core times spent while they are playing the PC games or the fragmented times when they are playing the mobile games. And basically, we are quite positive to it.

And our next question comes from the line of Jiong Shao from Macquarie.

William, Onward and Brandi, this is George calling on behalf of Jiong. I have 2 questions. The first one is on your MMO games. So I remember that you actually increased the pricing -- unit pricing for the time-based games by 50% in February. So I wonder what the results are kind of like in terms of like user churn or a pushback from users and also in terms of the point card that you sell. Actually, we found that you actually cut the discount rate to the distributors. So can you also elaborate a little bit more on that? [Chinese]

[Chinese]

So basically, we believe that the -- lately, the price increase, the performance of each or the trends are still be within our expectations and in terms of the time frame, because the price increase was announced and implemented in -- on the 10th of February, the effective date. And so far, the time frame is not that long. But so far, we still believe that the feedback and also the responses will be within our expectations. And in terms of the changes of the discounts of the -- to the distributors, which is just a 1% or so, were agents. We believe those 2 factors would not be very significant impact to our overall gaming performances. And as always, we believe that we've got a very strong capability in developing research -- and doing the research and developments of our new games.

My second question is regarding your mobile games. So first of all, is those mobile games developed by your in-house team or, actually, you acquired some mobile game studios to do that? And also, in terms of the genres, because when you mentioned that there will be some of this -- the extensions from these PC MMORPG games but also there will be more some mobile-only ones. So do you still -- are you going to focus on those more heavier mobile games or you will also do like some of these [indiscernible] mobile games? And also -- because you mentioned extension from PCs, so will you consider doing cross-platform, meaning PC plus mobile, the same account, the same character or you will still keep a separate mobile game? [Chinese]

[Chinese]

So basically, the account's verification process were basically the same for both users playing on the PC or on the mobile platforms. And basically, they would be adopting the cloud synchronization approach in achieving this aim. And in terms of the playing genders or the types, basically, we would also consider the features that can better utilize the fragmented times of the players while they are playing on the mobile handsets. And in -- thirdly, in terms of the overall strategies in doing our -- in achieving our mobile game strategies, we would not consider both our in-house developments and also the investment and also the potential acquisitions.

And our next question comes from the line of Andy Yeung from Oppenheimer & Co. Andy Yeung - Oppenheimer & Co. Inc., Research Division: My question is actually about your mobile apps. You obviously have a number of very popular mobile apps right now. Can you also let us know what other mobile app products are you developing right now? And also what's your go-to-market strategy and monetization strategy for those apps?

[Chinese]

[Chinese]

Okay. So -- well, with regard to the company's mobile application strategies, basically, we would take a diversified approach in achieving these strategies. So far, the applications that we have launched to the markets were covering the information categories like -- applications like the news, the news read and also the music. And other categories like the utilities type of applications, we've got the Youdao Dictionary and also the Youdao Cloudnote. And in terms of the education categories, we have our open education applications. And for the social networking applications, we have got another online dating application, so-called the Huatian. And in the future, I think our -- one of our main focus would be on the mobile games development. And we believe that, as always, our strategies would be a very full-coverage approach and also make sure that the products or services will be of the highest quality.

And our next question comes from the line of Thomas Chong from BOCI.

I have 2 questions. My first question is regarding your overseas expansion strategy. Is there any time line we should expect you guys to license your games to the overseas market, as well as any updates about your further cooperation with Blizzard, such as the Diablo III? And then I have a follow-up.

[Chinese]

[Chinese]

So basically, as for our overseas expansions or business developments, we would be marketing 2 ways. One would be, we have already made some success to certain of our game titles and in particular ways, one, which is Ghost II, which we believe that it has already recorded a [indiscernible] of the markets. Look forward of also pushing this product to the market. And secondly, with regard to our cooperation with Blizzard side, we would still deepen our goal overseas by considering our future licensing of our game titles that we consider fit and appropriate to the China market.

My second question is regarding marketing expenses. Given you have a lump of expansion packs going to be launched in the second quarter, how should we look at the market expenses in the second quarter compared to the same period last year?

With regard to the selling and marketing expenses, I think, basically, we're at the benchmark so to call because we do not give out any specific guidance about our financial results. But as the -- and you're asking for a benchmark, we do see that we will upkeep around 10% of our total revenues would be set aside for the selling and marketing services. And across the year, because there would be also different seasonalities and different seasons throughout the year and usually, first quarter will be the lowest one and you will also see that there has been a trending down in terms of the selling and marketing spending in the first quarter and -- but we will see that in the upcoming quarter, starting from Q2 or so and, especially, more stuff would be coming out in the Q3. We would expect that more -- certainly, marketing spending would be happening in the upcoming quarters. But in the general case, we do believe that on an annualized basis that we would try to strike a balance of upkeeping the -- a stable overall percentage of the -- our spending out of our total revenues.

And our next question comes from the line of Karen Tai from Piper Jaffray.

This is Karen calling in behalf of Mark. I have 2 follow-up questions, one is regarding your 10-year anniversary expansion pack for Fantasy Westward Journey. When do you expect this launch to take place?

[Chinese] So basically, the roll-off of the new expansion pack will hopefully be happening in the second half of the year.

And when is the annual dividend going to be paid?

I think, so far, the company has already got the board approvals in terms of the -- hopefully, the annual dividend policy. And I will give you more color when it comes to the more appropriate time when we determine the timing.

And at this time, I'd like to turn the conference back over to management for closing comments.

Thank you once again for joining us today. Please feel free to contact us. Cassia Curran is NetEase's IR manager based in Hangzhou, or The Piacente Group, if you have further questions. Have a wonderful day. Thank you.