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Giant Interactive Group Inc. (NYSE:GA)

Q3 2012 Earnings Call

November 14, 2012 8:00 PM ET

Executives

Richard Chiang – IR

Jazy Zhang – CFO

Xue Feng Ji – VP, R&D

Wei Liu – President

Analysts

Gillian Chung – Morgan Stanley

Karen Tai – Piper Jaffray

Martin Bao – CICC Martin

Chris Lai – Bank of America Merrill Lynch

Gloria Yu – Oppenheimer

William Huang – Barclays

Jia Long Shi – CLSA

Atul Bagga – Lazard Capital

Adam Krejcik – ROTH Capital Partners

Gregory Zhao – Citigroup

Operator

Good morning and good evening, ladies and gentlemen. I would like to welcome everyone to Giant Interactive Group’s Third Quarter 2012 Earnings Conference Call. After the presentation, there will be a question-and-answer session. Please follow the instructions given at that time if you would like to ask a question.

Now, I would like to transfer the call to the moderator, Mr. Rich Chiang, Investor Relations Director of Giant Interactive.

Richard Chiang

Good morning, ladies and gentlemen. Welcome to the third quarter 2012 earnings conference call for Giant Interactive Group. With me today are Ms. Wei Liu, President; Ms. Jazy Zhang, Chief Financial Officer; and Mr. Xue Feng Ji, Vice President of Research and Development.

As we proceed through our prepared remarks, we will refer to our results presentation, which can be downloaded from our website at www.ga-me.com. Following the remarks, Ms. Liu, Ms. Zhang and Mr. Ji will be happy to take your questions.

Before we continue, I would like to remind you that statements on this call that are not strictly historical in nature constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and as defined in the Private Securities Litigation Reform Act of 1995.

These forward-looking statements can be identified by terminologies such as will, expects, anticipates, future, intends, plans, believes, estimates and similar statements and among others, include statements regarding the company’s expectations for sequential growth in the fourth quarter 2012, the ability of the company to induce new game types to maintain its growth rate and profitability that are exceeding the industry average, the ability of the company to successfully diversify its revenues, the sustained progress and performance of ZT Online 2 after the launch of its first expansion pack and micro-client version, the sustained growth and diversity of the company’s user base after launch distribution and testing of pipeline games including MMO games.

They’re a part of the company’s portfolio diversification strategy. The ability for World of Xianxia to become another blockbuster MMORPG of the company, the ability of the company to implement a strategy in connection with webgames, such as expected commercial launches of Genesis of the Empire and The Sky, and the timetable for testing and releasing new games and expansion packs in the company’s game pipeline.

These forward-looking statements are not historical facts, but instead represent only our belief regarding future events, many in which by their nature are inherently uncertain outside of our control. Our actual results and financial condition and other circumstances may differ possibly materially from the anticipated results and financial condition indicated in these forward-looking statements.

Among the factors that could cause our actual results to differ from what we currently anticipate may include a deterioration in the performance of ZT Online 1 series, and ZT Online 2. Unexpected delays in developing expansion packs or in the timetable for testing and launching our games, our dependence on ZT Online 1 series and ZT Online 2, which currently account for the majority of our historical net revenues, failure of our webgames, MMO pipeline games, first FPS game or other diversification or distribution efforts to grow as successful as expected, our uncertainties with respect to the PRC legal and regulatory environments and the volatility of the markets in which we operate.

Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results of Giant to be materially different from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, risks discussed in filings with the Securities and Exchange Commission including our Annual Report on Form 20-F filed on April 23, 2012, and in our amended annual report on Form 20-FA for the fiscal year 2011. All forward-looking statements are qualified by this cautionary statement, and Giant undertakes no obligation to revise or update this information to reflect events or circumstances after today.

In addition, please note that references in the presentation to dollars refer to U.S. dollars.

Now, I would like to turn the call over to our CFO, Jazy Zhang. Jazy?

Jazy Zhang

Thank you, Rich. Good morning and good evening, everyone. I will begin by reading opening remarks from President Liu.

I’m very pleased with our third quarter performance which reflected some preliminary results from our efforts put in last year to diversify our portfolio and revenue stream by developing new games. Entering new game genres, attracting popular games from overseas to publish in China and extending our games into overseas markets. Our largest portion of revenues still came from the ZT Online 1 series, but our new blockbuster ZT Online 2 has become a major revenue growth driver, and we are delighted to see contributions from new games such as the micro-client version of ZT Online 2, Elsword and Allods Online.

This quarter, the ZT Online franchise remain our key growth driver. New contents for the various versions of ZT Online 1 were added, and ZT Online 2 continue its momentum from the launch of the first part of its new expansion pack in August. We expect these two games to continue to do well in the near term, especially after the launch of their new expansion pack in the coming month.

Additionally, the micro-client version of ZT Online 2 was launched in September. Since then, it has been acquiring new users everyday on Qihoo 360 platform and it’s starting to contribute to our revenue. In light of this, we plan to add additional service for this version during the fourth quarter. Also have – also did well this quarter by attracting additional younger gamers up to the launch of its summer holiday expansion pack.

Allods Online is helping to diversify the company’s user base with its 3D Western style fantasy and science fiction scene and is performing in line with our expectation, weeks set to launch its first expansion path in the fourth quarter.

In our MMO game pipeline, we have made substantial progress on the development of new game. The feedback we received from World of Xianxia limited account testing in September shows its potential to be another blockbuster game for Giant, demonstrating our ability to continue creating successful MMORPG in this competitive landscape. This game’s unique blend of hardcore MMO game play with social and team-based objectives plus a vivid 3D graphics will help grow our hardcore user base even further.

Close beta testing and soft launch status will be underway in the fourth quarter with large scale marketing to begin in March or April 2013 to avoid major events and holidays such as the Chinese New Year, when people often travel. Through collaborations with Internet platform and the Chinese military, we were able to do some free soft marketing for Glorious Mission and it has paid off. The recent released of an upgraded single-player campaign version has already attracted over 1 million download. Our development team is working on the online version and we’re also planning to conduct engineering testing during the first quarter 2013.

Lastly and most importantly, I would like to give you a progress report on our webgame pipeline. Engineering testing was conducted on Genesis of the Empire and The Sky during the third quarter and we expect the commercial launches in the first quarter next year.

Webgames is a pivotal business initiative for us in 2013 and our webgames strategy is designed to develop elite products for a new and fast growing market segment. We believe this depreciated games will bring value to Giant in a number of ways, including attracting new types of gamers by entering a new game genre and drawing in new partners from overseas markets to increase our global reach.

These strong Q3 results and pipeline updates offer a first look at our new revenue growth profile. With our solid pipeline of clients and webgames set to be unveiled in the fourth quarter and into the next year. We are hoping to see quality earnings growth going forward.

Our company is positioned for long-term growth as we continue to exercise our multi-year plan to broaden our user base through a more diversified game portfolio to increase our distribution channels by leveraging on our strong partnerships with Internet platform partners and to increase our geographic footprint through the development and licensing of innovative new games.

Even as we invest in growing our business by introducing new game types, by also exploring new market and user bases, we continue to successfully maintain growth rate and profitability that exceed the industry average.

With all these growth and diversification catalyst on top of the resilience of the online game industry, I am extremely excited about the future of Giant. I have complete confidence that the new games in our pipeline will enable us to reach new heights of success and growth.

This concludes the opening remarks from President Liu. And now I will walk you through our key operational metrics and financials for the third quarter.

Please refer to slide 8 of our presentation. Overall, we are very pleased to see underlying businesses performing extremely well. As you can see, all key operational metrics continue to grow steadily. Our total active paying accounts, or APA, were up 1.1% sequentially and 7.4% year-over-year to RMB 2.2 million in the third quarter 2012.

Average revenue per user, or ARPU, was RMB 238 in the third quarter 2012, up 2.4% sequentially and up 9.6% year-over-year. Average concurrent users, or ACU, were 694,000, up 1.3% sequentially and up 4.9% year-over-year. Lastly, our peak concurrent users, or PCU, were up 0.9% sequentially and up 1.4% year-over-year to RMB 2.3 million in the third quarter 2012.

The improvement in these operating metrics was mainly driven by the continued success of the ZT Online franchise. The sequential rise in APA demonstrated our ability to convert new ZT Online to users to paying users. In addition, as users progressed through the game, they gradually spend more in the game leading to a slight rise in our overall ARPU.

With the launch of our micro-client version, we are confident that ZT Online 2 can reach new heights. The healthy performance of our core gain portfolio contributed to our positive financial performance for the quarter which is illustrated on slide 9 and 10 of our presentation.

Net revenue for the quarter was $86.4 million, up 2.8% sequentially and up 18.6% year-over-year. Our core business, online game revenue grew 3.5% sequentially and 18% year-over-year to $83.3 million. Gross profit for the quarter was $74.5 million, up 1.5% sequentially and up 18.6% year-over-year. Gross margin was 86.2% in the third quarter 2012, compared to 87.3% in the previous quarter and 86.2% in the third quarter 2011.

Total operating expenses for the quarter were up 6.4% sequentially and up 24.7% year-over-year to $22.6 million. As a percentage of revenue, total operating expenses were 26.1% for the third quarter 2012, compared to 25.2% in the second quarter 2012 and 24.8% in the third quarter 2011. The sequential increase was mainly due to the decrease in government financial incentives which are recorded as an offset to operating expenses. The year-over-year increase was mainly due to share-based compensation expenses related to restricted shares granted at the end of November last year, as well as the general increase in cash compensation including raises and performance-based bonuses.

R&D expenses for the quarter were down 5.6% sequentially and up 55.5% year-over-year to $12.1 million. As a percentage of revenue, R&D expenses were 14% in the third quarter 2012 compared to 15.3% in the second quarter 2012 and 10.7% in the third quarter 2011. The sequential decrease was mainly attributable to higher expenses in the second quarter 2012 associated with some gaming projects no longer being capitalized and the lack of such expenses in the third quarter 2012.

The year-over-year increase was mainly due to increased compensation for R&D employees and share-based compensation related to the restricted shares granted at the end of November last year.

Sales and marketing expenses for the quarter were down 21.6% sequentially and down 24.7% year-over-year to $5.9 million. As a percentage of revenue, sales and marketing expenses were 6.9% this quarter compared to 9% in the previous quarter and 10.8% in the third quarter 2011. The sequential and year-over-year decreases in this expense item was mainly attributable to higher marketing expenses for ZT Online 2 in the second quarter 2012 to promote its first expansion pack and third quarter 2011 to support the open beta testing.

General and administrative expenses for the quarter were up 0.3% sequentially and up 52.2% year-over-year to $6.1 million. As a percentage of revenue, G&A expenses were 7% this quarter compared to 7.2% last quarter and 5.5% in the same quarter a year ago. The year-over-year increase was due to the share-based compensation expenses related to the restricted shares granted at the end of November 2011.

Moving on to our bottom line, net income attributable to the company’s shareholders during the quarter was up 1.4% sequentially and down 13.7% year-over-year to $49.6 million. The net margin for the quarter was 57.4% compared to 58.2% in the previous quarter and 78.9% in the third quarter 2011. The sequential increase in net income attributable to the company’s shareholders was mainly due to the increase in online game revenue, partially offset by the decrease in government financial incentives.

The year-over-year decrease was a result of a few one-time items such as: A, a significant increase in income tax expense which reflected an income tax benefit in the third quarter 2011 due to the one-time recognition of RMB 63 million in deferred tax assets; B, a decrease in other income of RMB 90 million which was mainly due to foreign exchange gains as the company obtained a more favorable exchange rate for the repatriation of cash for the special cash dividend paid during the third quarter 2011; an C, a significant in the net income attributable to non-controlling interest which reflected the financial results of the reorganization of the companies in development studio.

On a non-GAAP basis, excluding non-cash share-based compensation as well as the one-time items from the third quarter 2011, as I mentioned earlier net income attributable to company’s shareholders was up 0.9% sequentially and up 20.2% year-over-year to $54.5 million. Non-GAAP net margin for the third quarter 2012 was 63% compared to 64.3% in the previous quarter and 62.2% in the third quarter last year.

Basic and diluted earnings per ADS for the quarter were $0.21 and $0.20 respectively on a GAAP basis, and $0.23 and $0.22 respectively on a non-GAAP basis.

Moving on to our balance sheet on slide 11. As of September 30, 2012, our cash and cash equivalents and short-term investments totaled $372 million, compared to $314.6 million as of June 30, 2012. The sequential increase was due to the increase in cash receipt as a result of growth of online game operations and effective cost control.

In light of our consistently strong cash-generative business, we hope to provide our loyal shareholders a steady stream of dividend payments. Therefore, our board of directors has approved a change of our regular cash dividend from annual payments to semi-annual payments. This will take effect in 2013. The payment amount and date are subject to our board of directors’ approval and compliance with applicable law.

While we are pleased with our performance this quarter, we expect revenue growth to be higher in the fourth quarter 2012 when compared to the third quarter, due to contributions from multiple new games such as the micro-client version of ZT 2 and World of XianXia.

That concludes our prepared remarks. Once again, thank you for joining us today. We will now open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Due to time constraints for the call, participants are limited to two questions at a time. (Operator Instructions) Your first question today comes from the line of Gillian Chung from Morgan Stanley. Gillian, please go ahead.

Gillian Chung – Morgan Stanley

Hi. Thanks for taking my question. My question is on World of XianXia. Would you please share with us your observation from the second round of engineering testing? For example, how the users present is different from, for example, ZT Online 2 and compared to the same stage of development for a ZT Online 2 and other MMORPG games, how are they – what is the performance different from this game? And do you have any initial targets core for this game? Thank you.

Jazy Zhang

Thank you, Gillian.

Xue Feng Ji

For World of XianXia, currently after some limited account testing, the feedback and metrics that we’ve seen have definitely surpassed our expectations. This game is – has a lot of differences versus our flagship ZT series. For example, this game employs 3D graphics and the Chinese mythological fantasy theme. A popular theme in China, but again it’s slightly different from our classic historical theme in ZT Online and it’s also – which is also 2D.

And in terms of gameplay, as you know, ZT is famous for very large competitive large-scale PK battle whereas in World of XianXia, we’re focusing on more small team GvG gameplay and teamwork. And this leads – has led to a lot of stickier gameplay and users from those users who haven’t remained in the game so far.

So right now from the metrics that we’ve seen, World of XianXia could actually become our next blockbuster game and our biggest catalyst for growth next year.

Gillian Chung – Morgan Stanley

Thank you.

Operator

Your next question today comes from the line of Mark Marostica from Piper Jaffray. Mark, please go ahead.

Karen Tai – Piper Jaffray

Hey, everyone. This is Karen calling in for Mark. I have two questions. One is help us to compare the part one expansion pack versus part two of ZT 2 expansion pack in terms of the degree of the moving play and potential impact on the player’s interest level?

Jazy Zhang

Okay. Do you want to ask your second question?

Karen Tai – Piper Jaffray

Sure. And my second – one question at a time.

Jazy Zhang

Okay.

Xue Feng Ji

For our recent ZT 2 expansion pack, because the contents was so great because we had a lot of new content that we want to add, we decided to split it up into two parts. The first part was ready by the end of July and we released in August. This part of the expansion pack was targeting more existing users, and contained a lot of new in-game activities and promos.

Whereas the second part launch at the end of October – or in the fourth quarter contains new professions and new skills and should be more welcomed by new users were coming into the game. But overall, all of these features combined should provide a better game experience for all of the existing users in ZT 2.

Karen Tai – Piper Jaffray

Okay. Thank you. My second question is related to your Glorious Mission business model, how does Giant Interactive exactly get paid? Is there are a revenue share with the government? Can you just give us some further details?

Jazy Zhang

Sure.

Xue Feng Ji

For our upcoming Glorious Mission First Person Shooter game, the business model is going to be a free to play item-based game just like most FPS games on the marketplace today in China. And as for potential revenue sharing with the governments, the online version that we are developing will not require any revenue share with the government.

Karen Tai – Piper Jaffray

Okay. Thank you.

Operator

Your next question today comes from the line of Martin Bao from CICC. Martin, please go ahead.

Martin Bao – CICC Martin

Thank you for taking my question. Although we observed that we see that the ARPU and APA are both growing with our company, could you comment on this trend and is also from arbitration that it seems that the industry (inaudible) client game industry, the ARPU is also growing. Could you provide your comment on your thought on this trend?

Jazy Zhang

Thank you, Martin.

Xue Feng Ji

For our games, the ARPU has been actually relatively stable but has been up just only slightly quarter-over-quarter and year-over-year. In our – for most of our games, ARPU has been relatively stable. And in our opinion, that’s the only way to provide a superior game experience for our users because we’re not playing around too much with the modernization. And in the future, when we launch – in upcoming months, as we launch new games such as World of XianXia, our new webgame, and the micro client version of ZT 2, we expect APA to grow significantly more.

As for the rest of the industry, the trends that you’re seeing, ARPU may be growing because of changing spending habits in games, in client-based games or because some of these other games, their lifecycle has been more mature and users are spending more inside these games as well.

Martin Bao – CICC Martin

Thank you very much. My second question is regarding your webgames. I would like to know a little bit more about your operational strategy for your two webgames. Could you elaborate a little bit more?

Jazy Zhang

Sure.

Xue Feng Ji

For us, because we’ve always been a great developer of great games in the industry, for our webgames we’ve decided to operate them with online partners, online platform partners in the industry. So we’re taking a more open strategy for our webgames.

Martin Bao – CICC Martin

Thank you very much.

Operator

Your next question today comes from the line of Chris Lai from Bank of America Merrill Lynch. Chris, please go ahead.

Chris Lai – Bank of America Merrill Lynch

Thank you for taking my question. I wanted to see if you could comment on the potential dividend after this year-end?

Jazy Zhang

Okay.

Xue Feng Ji

For our dividend policy, as you know previously, it was annual – a regular annual dividend but to provide a steadier or more constant dividend payment stream to our loyal shareholders, we decided to start providing a semi-annual payments going forward next year. So the final terms, amounts and dates will still be subject to board approval.

And the rationale behind the decision is that although the global macro-economic conditions are relatively more unstable these days, the online game industry here is still very consistent, very stable. And for us, internally for Giant Interactive, we feel that we’re going to grow very well for next three years at least. So because of this we want to commend our loyal shareholders for being with us during this time.

Chris Lai – Bank of America Merrill Lynch

Thank you. That is all.

Operator

Your next question today comes from the line of Zhang Xiao from Macquarie. Zhang, please go ahead.

Unidentified Analyst

Hi, hello this is Ford calling on behalf of Zhang Xiao and good morning Liu, Xue and Chiang Zhang, Jazy and Rich. Congratulations on a good quarter. So I have two questions, and the first one is on the webgames so because you mentioned that webgame will be your pivotal initiative next year. And I remember before you said that you have like six webgames in the pipeline and this time you’ve mentioned that you will launch like two of them in the first quarter next year. So I wonder what’s the timeline of the following, of the release for what games?

And also what kind of relative contribution, expectation do you have for the webgames as of next year? Thank you. That’s my first question.

Jazy Zhang

(Foreign Language)

Wei Liu

For our Webgames, we mentioned two will be commercially launched in the first quarter 2013. And these two in our Webgame pipeline that have been developed a little bit earlier than the other ones. The other ones are started a little bit later and are currently still under development, so should be launching later after the two that we mentioned in our earnings release.

For our Webgame strategy, all of the Webgames that we are planning to launch are going to be ones that we feel are superior in quality than what’s available in the market these days.

As for revenue contribution from our webgames, currently we don’t have an exact forecast to give everyone yet. Our only goal at this point is to surpass industry standards in this regard, which is something that we feel is very achievable for us, and we feel that webgames will definitely become a very important part of our growth next year.

Jazy Zhang

Gillian, this is Jazy. I want to add a comment with respect to the revenue contribution from webgames for next year. Bear in mind that we will book the net revenue as a developer. The common practice in the market is that developers receive 30% of the growth and operators generally receive 70%. So we need to keep that in mind.

Unidentified Analyst

Sure. Thanks. And my second question is a follow-up on that. So you mentioned that you are going to (inaudible) results, operate in platforms to operate your webgames. But I wondered, do you consider to operate your games by yourselves also? And what’s – basically, what’s the potential margin impact once you enter into this webgame arena?

Jazy Zhang

Sure. I will let Mr. Ji comment about the self – potential self-operation and then I will answer your question with respect to the potential margin impact.

Unidentified Analyst

Thanks.

Jazy Zhang

(Foreign Language)

Xue Feng Ji

For operation of webgames, it will depend whether we operate them ourselves or let the third party Internet platforms do it for us. It will depend on each project, but initially we believe that we’ll probably let the platform companies operate them for us and potentially operate them ourselves in the future.

Jazy Zhang

With respect to the margin impact for webgames business, if we were to 100% rely on outside operators to run the games for us, as I mentioned earlier that we will be booking the net revenue on the top. So we would expect slower paced growth. However, since that we will not be paying much of cost of sales traverse customer service as well as marketing, sales and marketing expenses so the overall operating margins from that piece of business would be higher than normal.

Unidentified Analyst

Okay, thank you very much. That’s very helpful. Thanks.

Jazy Zhang

Thank you.

Operator

Your next question today comes from the line of Andy Yeung from Oppenheimer. Andy, please go ahead.

Gloria Yu – Oppenheimer

Hi, this is Gloria Yu. I have two questions on behalf of Andy Yeung, and congratulations on a solid quarter. My question is could you share some colors on the Apple (inaudible) ratio of the micro-client version of ZT Online 2. How is it compared with the traditional MMORPG? Thanks.

Jazy Zhang

Sure, Gloria.

Xue Feng Ji

For the micro-client version of ZT 2 operated on Qihoo 360’s platform, because this project has been underway only recently, we’re still gathering all the numbers and performance metrics for this project. But so far, it seems that the APA and the ARPU would resemble more figures you would see from webgames.

However, the difference is that the life cycle would be much better than a simple webgame. But – so we will continue to keep monitoring these trends as time goes on.

Gloria Yu – Oppenheimer

Thank you. That’s very helpful.

Operator

Your next question today comes from the line of William Huang from Barclays. William, please go ahead.

William Huang – Barclays

Hi. Good morning. Thank you. Congratulations to a great quarter. I just want a follow-up question on micro-client version. How many percent of ZT 2 users did you see that actually logging ZT 2 from micro-client version? And given that your comment on the ARPU and APA similar to webgame. But some webgame ARPU seems to be quite high. So did you see ZT 2’s ARPU to be diluted or slightly improved from after launching the micro-client version? And I have a second question. Thank you.

Jazy Zhang

Sure. Thanks, William. (Foreign Language)

Xue Feng Ji

For the micro-client version of ZT2, the ARPU levels in that game are more similar to webgames currently in the marketplace. But as you know, webgames right now, their ARPU can vary a lot from very low to very high. Ours is probably not – is not on the high side because we don’t want to over-monetize. Some of the high ARPU webgames in the marketplace, their life cycles are very short, they over-monetize their users in order to make a quick buck and that’s definitely not going to be our strategy for this project. So we want to have a more sustainable business model in terms of our micro-client version

As for user differences, users in our – on our client-based ZT2 is – our traditional hard core users. But the users that we’re getting in the micro-client version on Qihoo’s platform are more like web users, more casual or newcomers. So there’s very minimal or almost no cannibalization that we’ve seen through our existing user base.

But one positive trend that we can sit potentially foresee is that because Qihoo is such a large platform, they may be able to get some of the users that had already tried and left RZP2 some time ago back into the market plan version of the game which would be very positive for us.

William Huang – Barclays

Okay. Thanks a lot. Second question is about ZT franchise. Just want to confirm that for Q3, the contribution from ZT is still higher than ZT 2, right? And then did you see the stable ARPU within the quarter for ZT standalone basis? Thank you.

Jazy Zhang

Yes. Overall, we normally as a common practice in the industry, we don’t break down the performance for each game. But however, we do – we can’t give you some color in terms of the ranking. Yes. ZT series is still the number contributor and ARPU is still stable.

William Huang – Barclays

Okay. Thank you so much.

Jazy Zhang

You’re welcome.

Operator

Your next question today comes from the line of Jia Long Shi from CLSA. Jia Long, please go ahead.

Jia Long Shi – CLSA

Hi. Thanks. Good morning, (inaudible) Jazy and Rich. Congratulations on a very solid quarter. I have a question, follow-up question on the webgames. And Jazy you just mentioned the operating margin for webgames should be higher than your investing than – should be higher than your margin of your investing games. So just wondering if you can provide some colors on the margin range of your webgames? That will be very helpful. I have a follow up.

Jazy Zhang

Okay. I think I will only comment on the margin if the overall size of our webgame business reach in a sizeable relative to our overall game portfolio. In which case, we would expect the operating margin to be in a range of 70% to 75%.

Jia Long Shi – CLSA

Okay.

Jazy Zhang

That’s more of a normalized margin. So in the beginning when we released our launching the webgames one-by-one, let’s say next year, we only have the majority of the certain contribution can found in two webgames. In this case the operating margin would not be in a range that I just mentioned. Although the number that I mentioned is more of a normalized, it’s a sizeable business to us. I think it’s hard to really put a single on that. So this is just a rough estimate. Yes webgame business becomes 15% of our total revenue contribution.

Jia Long Shi – CLSA

Okay, thanks. And I have another question on Xianxia and you are operating that game in collaboration with Qihoo, and as you mentioned on the prepared remarks that the audience seems to be doing very well in this release. And I just wonder how do you think of Qihoo as a game operation platform? Do you think it is more or that has impacted as other online distribution, online game distribution channels you have used before?

Through our cooperation with Qihoo 360, as everyone knows they have a large and broad user base and – which is a very positive thing. And they have a lot of capabilities when it comes to getting users into your product and services.

But as you know, the cooperation has just started. In the short time period, it’s been, overall, pretty good, but we’ll have to see as time goes on.

Operator

Your next question today comes from the line of Atul Bagga from Lazard Capital. Atul, please go ahead.

Atul Bagga – Lazard Capital

Hey guys. Thanks for taking my question and congratulations on the quarter. I have actually three questions for you. Number on ZT and ZT 2, internally, I mean, what do you – how do you guys see the lifespan of these two games? In the best case scenario and the worst case scenario, how long do you think this franchise is going to last?

And second question, Jazy, you have managed the ship very, very tightly. Your management – your group CapEx spend is very much under control. As ZT and ZT 2 contribution goes down, overall, how do you see the margin profile change as the new games are coming and contributing more? Games have – where you probably have to spend more on the marketing and development.

And lastly third question, Jazy. I think on the last earning call you have talked about 50% margin expectation for 2012 and about 50% net margin for 2013. Is there any change or those expectations are still the same? Thank you.

Jazy Zhang

Thanks, Atul. I will pass the first question to Mr. Ji and I will take care of your question two and three.

Atul Bagga – Lazard Capital

Thank you for that.

Jazy Zhang

Sure.

Xue Feng Ji

(Foreign Language)

For our ZT1 and ZT2, ZT Online franchise, the lifecycle of these games can be very long. As you know, ZT1 is already in its seventh year and still very stable today, so I guess the worst-case scenario is at least seven years. And the best case scenario, as our CEO has said previously, it’s 10 years should not be a problem either for the best case scenario for a good game.

When a good successful online game becomes this large, it takes on its life of its own, it has its own social network. People come and play the game not because of the game play itself because sometimes they want to see their friends or enemies and just based on interaction in the game. So a good online game like this can last a very, very long time.

Jazy Zhang

Okay to answer your second question which relates to the margin for next year. I think that several factors we’ll need to consider. One is the contribution from webgame business. As I mentioned earlier that, if you look at this as a – on a standalone basis, the overall operating margin should be high. However we do expect – we do not expect significant revenue contribution of webgames next year. At least, it’s not going to cause any significant impact to our margin.

And the second factor I would like you to consider is the minority interest. We expect the minority interest cause out to grow by 1% to 2% next year as our games that have been launched are getting more and more profitable. And with regard to your third question, for 2012 the overall operating margin is the on track at about 60%. For 2013, the operating margin should be in the mid-50s, comfortably.

Atul Bagga – Lazard Capital

Very good, thank you.

Jazy Zhang

Thank you.

Operator

Your next question today comes from the line of Adam Krejcik from ROTH Capital Partners. Adam, please go ahead.

Adam Krejcik – ROTH Capital Partners

Yes hi thanks. I just had one question. For Q4 guidance, you said you expect a higher sequential growth rate versus this quarter. So I was just wondering if you can quantify where most of that growth come from, the new ZT 2 Online expansion pack or will it be driven more by the launch of World of Xianxia? Thanks.

Jazy Zhang

Thanks, Adam. So the additional growth in Q4 is driven by several gains including World of Xianxia even though we only are going to do a soft launch as well as the micro-client version of ZT Online 2 and several other smaller new games.

Adam Krejcik – ROTH Capital Partners

Is there any way you could kind of rank it in order in terms of internally which are going to have the biggest contribution to growth added the micro-client version World of Xianxia and the new expansion pack?

Jazy Zhang

World of Xianxia and micro-client version.

Adam Krejcik – ROTH Capital Partners

Okay. Perfect. Thank you very much.

Jazy Zhang

You’re welcome.

Operator

Your next question today comes from the line of Gregory Zhao from Citigroup. Gregory, please go ahead.

Gregory Zhao – Citigroup

Hello and congratulation to the strong quarter and thanks for taking my question. I have a follow-up question about webgames design. We can see that the lifecycle of the webgames are much shorter than the traditional MMO games and there are several names in your pipeline. And about the design of the webgames, in the future how and where do we expect to get the inspiration or sources for the webgame content meaning convert from the Giant existing MMO games or inevitably design some new games to cater to webgame users in trade and your mind was the key to guarantee the success of webgames. Thanks.

Jazy Zhang

Thanks, Greg.

For our game design’s philosophy in webgames, even though we started a bulk of our webgame design and development this year, but we feel that we have a competitive advantage and lots of experience in designing these types of games. Currently, the marketplace, a lot of the current webgames, their lifecycles are shorter than client-based and MMOs, not because of user behavior or user habit, but because of the game design. Because sometimes, they over monetize so that users get agitated or the lack of a social interaction features in the game that make it more sticky.

These are areas that we feel that we can definitely bring a lot to the table. Each of our web game projects are definitely going to have its unique characteristics or themes. But overall, of course, we can leverage our experiencing in creating large-scale successful MMOs such as our ZT franchise, leverage of the game design that we’ve learned from making those hit products, and combine them with unique themes, innovative themes and features for each web game that we plan to release.

Gregory Zhao – Citigroup

(Foreign Language)

Jazy Zhang

As for the keys to success in webgames, we believe that the key to success is fulfilling users’ needs. Users taste and preferences are changing very fast in the web games segment, but that’s been true of MMO games, MMORPGs since day one as well. So ever since that we came out with ZT Online 1 many, many years ago, we definitely gone used to keeping pace with the users changing preferences in the Chinese online game platform, which is why we think we can replicate that kind of same success in the webgames segment going forward as well.

Gregory Zhao – Citigroup

Thanks.

Operator

Ladies and gentlemen, as there are no further questions at this time, I would like to hand the conference back to Mr. Rich Chiang. Please continue.

Richard Chiang

Thank you, everyone for joining us today and we look forward to talking with you about our progress in the near future. Have a nice day.

Operator

Ladies and gentlemen, that does conclude the conference for today. Thank you all for your participation. You may all disconnect.

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Source: Giant Interactive Group Management Discusses Q3 2012 Results - Earnings Call Transcript
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