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Perfect World Co., Ltd. (NASDAQ:PWRD)

Q3 2012 Earnings Conference Call

November 19, 2012 8:00 PM ET

Executives

Joanne Deng - IR Manager

Michael Yufeng Chi - Chairman & Co-CEO

Robert Hong Xiao - Co-CEO, Chief Operating Officer

Vivien Wang - VP, IR & Corporate Communications

Kelvin Wing Kee Lau – CFO

Analysts

Wendy Huang – CIMB

Eddie Leung – Bank of America/Merrill Lynch

Mark Marostica – Piper Jaffray

Muzhi Li – Citigroup

Thomas Chong – BOCI

Timothy Chen – Morgan Stanley

Martin Bao – CICC

Jiong Shao - Macquarie

Jialong Shi - CLSA

Atul Bagga - Lazard Capital

William Huang - Barclays

Operator

Hello ladies and gentlemen. This is Jenny. I’ll be the operator for this conference call. I’d like to welcome everyone to the Perfect World Co., Ltd. Third quarter 2012 earnings conference call. All lines have been placed on mute to prevent background noise. After the presentation, there will be a question-and-answer session. (Operator instructions). In fairness to all the callers, please keep your question limited to one and then you’re free to return to the queue.

Now I’d like to turn the call over to Ms. Joanne Deng, Investor Relations Manager for Perfect World. Ms. Deng, please proceed.

Joanne Deng

Thank you operator and thank you everyone for joining us today for Perfect World’s third quarter 2012 earnings release conference call. We distributed our unaudited earnings release earlier today. You may find a copy of the press release on our official website or through the newswires.

Today, you will hear from Mr. Michael Chi, our Chairman and Co-CEO and Mr. Robert Xiao, our Co-CEO, who will give us a brief overview of the quarter and a brief update on our business. After that, Ms. Vivien Wang, our Vice President of Investor Relations and Corporate Communications will take us through some of our latest operational developments. And then she will pass the call to Mr. Kelvin Lau, our CFO, who will take you through our financial performance in the third quarter of 2012. Following the prepared remarks, Mr. Chi, Mr. Xiao, Mr. Lau and Ms. Wang would be available to answer your questions.

Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the US Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectation. Potential risks and uncertainties include, but are not limited to those outlined in our public filings with the SEC, including our annual report on Form 20-F.

For more information about these risks and uncertainties, please refer to our filings with the SEC. Perfect World does not undertake any obligation to update any forward-looking statement as a result of new information, future events or otherwise, except as required under applicable law.

Our earnings release and this call include discussions of certain non-GAAP financial measures. Our earnings release contains a reconciliation of the non-GAAP measures to the most directly comparable GAAP measures and is available on our website at www.pwrd.com under the Investor Relations section.

I would now like to turn the call over to Michael.

Michael Yufeng Chi

Thank you, Joanne. Thank you all for joining our call today. During the quarter, we mainly focused our company development for our portfolio, decelerating in-game promotion activities. As we expected, this resulted in a slightly softer overall performance of our existing games compared with the previous quarter. However, our total revenues for the quarter were about 3% higher than last quarter and came in ahead of the high end of our expectations, primarily due to solid revenue contribution from our new game.

In September, we released Torchlight 2, a pay-per-install game developed by our majority-owned subsidiary, Runic Games, a top-tier game development studio based in the U.S. we also launched Return of the Condor Heroes in China. This is an exciting turn-based martial arts MMORPG adapted from Louis Cha’s classic novel of the same name. We expect revenue contribution from this new game will gradually ramp up in Q4.

In addition to bringing new titles to our gamers, we continued to provide exciting new content to players for our existing games through regular releases of expansion packs to maintain their healthy life cycles. For example, we released expansion packs towards the end of the Q3 or our flagship titles, Zhu Xian and Perfect World II.

At the same time, we also continue expanding our deep and diverse pipeline. We have a number of attractive titles of different types that are currently in development, including our lineups of MMORPGs and web games. We look forward to introducing these titles such as our highly-anticipated MMORPGs Swordsman Online, Saint Seiya Online and Legend of the Condor Heroes to gamers and believe they will become new growth drivers for our business.

I will now pass the call to Robert who will give you further review of our business.

Robert Hong Xiao

Thank you, Michael. In addition to our great titles being developed in China that Michael just mentioned, we have a number of global titles in our deep pipeline. Our Cryptic Studio in the U.S. is currently developing the highly-anticipated MMORPG Neverwinter, which plan to initially launch in North America. Cryptic Studios, as well as our other specialized R&D studios across the world, not only bring more world-class entertainment to our pipeline, but also further strengthen our well-established R&D capabilities worldwide, playing an important role in our globalization strategy.

Dota 2 is another world-class title we are very excited about. This game features a unique mix of action, RTS and RPG gameplay. Recently we obtained exclusive rights to operate this game in China. We look forward to leveraging our vast operational experience in China to bring exciting new titles and world-class entertainment to our players here.

In addition to our strong operational capabilities in China, we also continue strengthening our operational network overseas which is also an important part of our globalization strategy. During the third quarter, we continued to make progress in our overseas operations and licensing activities. Recently we successfully launched licensed games, Dark Blood and RaiderZ, through our overseas subsidiaries in Japan and the U.S., respectively. Additionally, we have signed several new licensing agreements with overseas operators to bring more of our games to new geographic markets during the quarter.

Looking forward, we plan to continue to capitalizing our key competitive advantages in our deep and diverse portfolio and pipeline, strong global R&D capabilities, and our extensive global operating network to deliver exciting world class entertainment and innovative titles to gamers all over the world.

Next I’ll pass the call to Vivien who will take you through some of the recent operational development in both China and overseas. Vivien.

Vivien Wang

Thank you, Robert. To lengthen the life cycles of our existing games and ensure the long term sustainability of our business, we continued developing expansion packs and further enhancing content for the games in our portfolio. During the quarter, we released several expansion packs, including Peach Blossom Wonderland for Legend of Martial Arts, Chi Bi Heroes for Chi Bi, Gate of Destiny for Battle of the Immortals, Uprising Dynasties for Perfect World II and Dawn of Judgment Day for Zhu Xian.

Recently, we also released a number of expansion packs, including Legend of Yellow Emperor for Dragon Excalibur, Heavenly Scripture for Fantasy Zhu Xian, the Wolf for Forsaken World and Call of Heaven for Perfect World.

Meanwhile, we also continued to make progress in our overseas business. In addition to the launches of Dark Blood and RaiderZ through our overseas subsidiaries in Japan and the US respectively as Robert mentioned. We also licensed our Battle of the Immortals to Turkey and Azerbaijan and Empire of the Immortals to Turkey, Azerbaijan and Indonesia during the quarter.

In the future, we will remain dedicated to delivering innovative, high quality entertainment to gamers in China and across the world.

I will now pass the call over to Kelvin for a review of our financials.

Kelvin Wing Kee Lau

Thank you, Vivien. Now for the third quarter 2012 financials. Total revenues were RMB695.8 million in 3Q12, compared with RMB676.4 million in 2Q12 and RMB708.9 million in 3Q11.

Online game operation revenues, which include both domestic and overseas online game operations, were RMB608.2 million in 3Q12, as compared with RMB626.4 million in 2Q12 and RMB643.2 million in 3Q11. In the third quarter, we decelerated in-game promotional activities and continued to focus on content enhancements in order to maintain a healthy life cycle for our existing games.

ACU for games under operation in mainland China was approximately 601,000 in 3Q12, compared with 739,000 in 2Q12 and 828,000 in 3Q11. During late second quarter and throughout the third quarter, we stepped up our anti-cheating efforts for certain games in order to maintain a healthy and fun gaming environment for players. The decrease from 2Q12 was mainly due to more stringent anti-cheating efforts, as well as adverse seasonality factors that affect user traffic during the third quarter. Additionally, expansion packs for certain games were released towards or after the end of the third quarter, resulting in user traffic remaining at typically previous levels.

Licensing revenues were RMB39.0 million in 3Q12, as compared with RMB46.9 million in 2Q12 and RMB55.8 million in 3Q11. The decrease from 2Q12 was mainly due to lower initial license fees as we had no new launches through our partners in overseas markets in 3Q12.

Other revenues were RMB48.6 million in 3Q12, compared with RMB3.0 million in 2Q12 and RMB9.9 million in 3Q11. The increase from 2Q12 was primarily due to the contribution from the English version of Torchlight 2 released in 3Q12.

Cost of revenues was RMB128.9 million in 3Q12, compared with RMB126.6 million in 2Q12 and RMB121.2 million in 3Q11. Gross margin was 81.5% in 3Q12, compared with 81.3% in 2Q12 and 82.9% in 3Q11.

Operating expenses were RMB457.5 million in 3Q12, compared with RMB394.6 million in 2Q12 and RMB393.9 million in 3Q11. The increase in operating expenses from 2Q12 was due to increases in sales and marketing expenses and R&D expenses in 3Q12.

R&D expenses were RMB197.1 million in 3Q12, compared with RMB189.7 million in 2Q12 and RMB170.6 million in 3Q11. The increase from 2Q12 was primarily due to an increase in staff cost.

Sales and marketing expenses were RMB177.1 million in 3Q12, compared with RMB121.8 million in 2Q12 and RMB146.7 million in 3Q11. The increase from 2Q12 was largely due to the increase in advertising and promotional expenses associated with the launch of the our new game, Return of the Condor Heroes, and releases of several expansion packs for its existing games, including the flagship titles Zhu Xian and Perfect World II.

G&A expenses were RMB83.3 million in 3Q12, compared with RMB83.1 million in 2Q12 and RMB76.5 million in 3Q11.

Operating profit was RMB109.4 million in 3Q12, compared with RMB155.2 million in 2Q12 and RMB193.9 million in 3Q11. Non-GAAP operating profit was RMB127.5 million in 3Q12, compared with RMB172.5 million in 2Q12 and RMB221.3 million in 3Q11.

Income tax expense was RMB29.1 million in 3Q12, compared with RMB38.1 million in 2Q12 and RMB78.8 million in 3Q11. The decrease from 2Q12 was primarily a result of the change in the operating profit in 3Q12.

Net income attributable to the Company’s shareholders was RMB86.2 million 3Q12, compared with RMB158.2 million in 2Q12 and RMB143.6 million in 3Q11. Non-GAAP net income attributable to the Company’s shareholders was RMB104.3 million in 3Q12, compared with RMB175.5 million in 2Q12 and RMB171.1 million in 3Q11.

Basic and diluted earnings per ADS were RMB1.78 and RMB1.77 respectively. This compares with RMB3.28 and RMB3.25, respectively, in 2Q12, and RMB2.96 and RMB2.83, respectively, in 3Q11. Non-GAAP basic and diluted earnings per ADS were RMB2.16 and RMB2.14 respectively, in 3Q12, as compared to RMB3.64 and RMB3.60, respectively, in 2Q12, and RMB3.53 and RMB3.37, respectively, in 3Q11.

In terms of financial guidance, based on our current operations, total revenues for the fourth quarter of 2012 are expected to be between RMB661 million and RMB696 million, representing a flat to slight decline from the third quarter of 2012. We successfully released the English version of Torchlight 2, a popular pay-per-install game, which contributed to revenues in the third quarter. As this is more of a one-time fee in nature, the company does not expect the revenue contribution from this game to be as significant in the fourth quarter. On the other hand, our new game, Return of the Condor Heroes, is expected to contribute additional revenues for the fourth quarter, but it will take time to ramp up gradually.

This concludes our prepared remarks for today. We are happy to take your questions now. Operator, we are ready for questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions). Your first question comes from the line of Wendy Huang from CIMB. Please ask the question.

Wendy Huang – CIMB

Thank you for taking my questions. I just wonder, at those regions for AC decline in Q3 one off or should we expect to see the continuing impact from those regions in the future? And also you mentioned the inter-trading program you conducted in Q3. I just wonder, on which game that you actually conducted those efforts on? And also for your Q4 guidance, I think the midpoint of your revenue guidance suggests slight decline. So where was decline coming from? Thank you.

Kelvin Wing Kee Lau

Thank you, Wendy. I think in response to your question is I think the major reason for the decline in issue for adding in Q3 this year, there’s mainly three reasons. One is as far as mentioned in the remark, I think we talked our stringent anti-cheating effort in US in some of our selling existing games. This is the major reason for the decline in issue in this quarter, especially in Perfect World II. We have taken very tough and stringent anti-cheating efforts to clear away all those gold mining studios and robots because Perfect World II is quite alright now. So I think in order to maintain a good environment for the game is necessary for us to probably establish stringent anti-cheating activities to get away all those robots. Another reason is the seasonality factor is also a major reason for the decline, especially during the summer vacation some of the teenagers I think we were engaged in some other traveling or summer jobs.

So ACU I think naturally will decline a little bit in Q3 and the third reason is I also mentioned in the remarks is that we have two big expansion packs to launch for flagship games Zhu Xian and Perfect World II. So normally before the new expansion pack launched I think our issue number will maintain at the previous level. I think the good news is after we launched Zhu Xian expansion pack we saw that adding the issue number for Zhu Xian climbed up a little bit after we released the expansion for Zhu Xian. And also Perfect World II right now the issue number is quite stable after launching the expansion pack. So I think this answer for your question number one. Question number two, regarding the guidance.

What I said is in Q3 Torchlight 2 contributed quite a lot to revenues in Q3. But most of the – I think the major sales they happened at the end of Q3. So we don’t expect that the Torchlight 2 the sales will contribute quite a lot in Q4. So in Q4 there’s no contribution from Torchlight 2. For all the other games, I think we are trying to maintain the same level of revenue as that in Q3 because China’s New Year is coming in the coming year Q1. So we’ll adding to more monetization in Q1 in the coming year instead of two in the monetization Q4 this year. So I think that’s the major reason we’ve guided revenue at a (inaudible) a little bit down in Q4. Thank you.

Wendy Huang – CIMB

Thanks, Kelvin.

Operator

Your next question comes from Eddie Leung from Merrill Lynch. Please ask your question.

Eddie Leung – Bank of America/Merrill Lynch

Hey, good morning. Just want to get a sense on the sales and marketing expenses going into the fourth quarter after you launched a couple of expansion packs. And then secondly, also a couple of accounting questions. It seems like we have increasing minority interest in the third quarter. so just wondering if you could share more color on that. And then secondly, also want to get sense on the C&C progress in Japan in the third quarter. Thank you.

Kelvin Wing Kee Lau

Eddie, thank you. Regarding the sales and marketing expenses, I think yes, in Q3 we incurred quite a lot of sales and marketing expenses because we need to do some prelaunch promotional advertising activity for our new game Return of the Condor Heroes. But I think going to Q4 we don’t have any major game launch and also no big expansion pack for our existing games. So I expect the sales and marketing expenses in Q4 will – compared with Q4 will go down a little bit. So this is some color on the sales and marketing expenses. Vivien?

Vivien Wang

Okay. So the second question about the minority interest, it’s actually also because of the release of Torchlight because we majority own the studio of Runic. So after the launch of Torchlight it’s making a nice profit for the subsidiary. That’s why there is a increase of minority interest.

Kelvin Wing Kee Lau

Yeah. Thanks, Eddie.

Operator

Your next question comes from the line of Mark Marostica from Piper Jaffray. Please ask the question.

Mark Marostica – Piper Jaffray

Thank you for taking my question. You have a good list of pipeline games coming up for next year. Could you give us a sense of the timing of the release of each of the games in your pipeline next year maybe by first half, second half, or however you can describe it? Thanks.

Robert Hong Xiao

Mark, thank you for the question. We do have a strong pipeline for next year. It started early in the first half of the year. We’re going to have the Legend of the Condor Heroes. The Legend of the Condor Heroes will be the second half of the year and then of course midyear we’re going to launch this highly anticipated game the Swordsman and then the first half of the year we’re going to have the Heaven Sword and Dragon Excalibur, the web version of this game. And also sometime next year we’re going to have this Saint Seiya. This is our own developed game and at the same time we anticipate the Dota 2 which is another famous game. We’ll be ready whenever we get the licensing from the government, certification from the government. And also our overseas developed game Neverwinter will be launched first in the US in I think the first half of the year and then we’ll try to launch it everywhere in the world whenever we have our operation throughout the year.

Mark Marostica – Piper Jaffray

Thank you for the color.

Operator

Thank you for the question. Next question we have Muzhi Li from Citigroup. Please ask the question.

Muzhi Li – Citigroup

Thanks for taking my question. I would like to ask you about the equity investment in your balance sheet. Looks like you made some investments in – add some numbers in this. Can you give me some color that how much monies are left in your venture capital commitment and what kind of your equity investment that currently in your portfolios? Thank you.

Kelvin Wing Kee Lau

I think you are both adding the equity investment by presenting the total amount of money we contribute into the VC fund. I think we mentioned that we established our VC funds we are acting as a limited partner in the VC fund. So I think this around RMB200 million contribution is I think the first stage contribution we’re contributing into the VC fund. Right now the VC fund has already established, but I think we still haven’t actually invested in some titles right now, but I think we are actively looking for good service deal in west. So I think for the quarter the slight fluctuations is the interest we earned from the deposit we get from the fund because we deposit the cash in the paying account before we invest. So I think the slight fluctuation is the interest behind.

Muzhi Li – Citigroup

I see. And my second question is regarding the pipeline. You said the Condor Heroes will release next quarter. So that’s a different game with the return of the Condor Heroes, am I right?

Kelvin Wing Kee Lau

Yes, you’re right. I think the Legend of the Condor Heroes, the 3D MMORPG, I think the newly launched game Return of the Condor Heroes which we launched by the end of Q3 this year is a 2D turn based game. So in terms of gameplay there’s a 2D turn based and the other one, Legend of Condor Heroes is a 3D MMORPG.

Vivien Wang

And Muzhi just to clarify, Legend of the Condor Heroes, we expect to release this game in second half next year.

Muzhi Li – Citigroup

Okay. Thank you very much.

Operator

Your next question comes from the line of Thomas Chong from BOCI. Please ask your question.

Thomas Chong – BOCI

Hi. Good morning. I just want to get a sense about the company strategy going forward. Are you guys going to focus more on client based game in domestic market or focusing more on your globalization strategy in overseas markets or are you guys going to focus more on the red games or the mobile games? Thank you.

Robert Hong Xiao

Thomas, that’s a great question. I think our strategy has been very clear, that we are moving forward to become a global company. So, not only China. Domestic market in China is very important for us, but at the same time our global expansion is a key strategy we’re driving forward. In terms of what specific field of the game type we’re going to get into, actually we’re in every part of the space in this game industry. We do specialize in client based MMORPGs, but at the same time we have been investing in web based games and also mobile games. We are trying to enlarge our portfolio to make sure that we do have a long line of different types of games. The reason is we are monitoring the market all the time and make sure our games would be happy. Whatever they want we’re going to try to provide the necessary, the best content for them. So to summarize number one, we are moving forward as a globalization company. Number two is we are in every space of the game development.

Thomas Chong – BOCI

Thank you.

Operator

We have the next question from Timothy Chen from Morgan Stanley. Please ask your question.

Timothy Chen – Morgan Stanley

Hi everyone. Good morning and thanks very much for taking my question. Basically I have two questions. I just want to get an understanding of your core games performance on a sequential basis in the quarter. That would be my first question. And the next question would be, I want to get more clarification on your sales and marketing expense in fourth quarter. you just mentioned that the sales and marketing expenses will go down a little bit in fourth quarter, but given that the lack of new game launch and expense impact, wouldn’t that be -- the fourth quarter would it be similar to that of second quarter or compared to the fourth quarter last year, how does that compare? Thank you very much.

Kelvin Wing Kee Lau

Thank you, Tim. I think I mentioned a lot of times that our company policy does not allow me to disclose I think individual games performance in earnings call. So what I said is, that’s why I said Q3 I think our actual revenue is better than what we expected in the guidance is mainly because of the Torchlight 2. I think the sales of these games in the US is better than what we expect. In China I would say I think our games are quite stable. Some small games like Immortal or Legend of Martial Arts will help some the seasonal fluctuation. But I think it’s not a big issue for us. I think up to now we still think. So far I think our (shooting) game in China is still quite stable. Regarding the sales and marketing expenses, that’s why I said I believe in Q4 we don’t have any major game launch and also no big expansion pack going to be launched. So I expect sales and marketing expenses compared with Q3 this year would go down a little bit.

Timothy Chen – Morgan Stanley

But it would still be high than same quarter?

Kelvin Wing Kee Lau

We’ll be lower than Q3, okay? I can’t tell whether it’s higher in Q2 or not at this moment.

Timothy Chen

Okay. Thank you.

Operator

Thank you. And we have the next question from the line of Andy Yeung, from Oppenheimer. Please ask the question.

Unidentified Analyst

Hi, this is (inaudible), filling in for Andy Yeung. Thank you for taking my question. Could you talk about the launch schedule of your coming browser games and also some of the unique features of those games? Thank you.

Vivien Wang

I’m sorry. Can you repeat your question? Launch schedule for what? Web game? Browser game?

Unidentified Analyst

Yeah.

Robert Hong Xiao

I think we do have – I am not going to break into details on the browser side because we have multiple launches this starting early next year, but basically we are trying to tap into different specific niche market of the browser game for example, we are going to have some very – there are PG type of game, action based and we do have some more social based, it’s a light tough type of game. We do have at least four or five in the pipeline we are looking forward to launch. And then of course one of the most important heavyweight more like MMORPG type of game is The Heaven Sword and Dragon Saber, which is actually we sort of modified from the MMO version. So it’s a combination of different things, different features and we try to touch different niche market and satisfy different needs from our variety of types of customers.

Unidentified Analyst

Thank you.

Operator

Thank you. And we go to the next question from Martin Bao, from CICC. Please ask the question.

Martin Bao – CICC

Thank you for taking my question. I have two questions. One question is regarding the Dota 2. I would like to know the general expectation from the Company on this game and your operational strategy given the high competition within this particular market and the second question is more regarding to the Company's view and strategy on the mobile game market, will the company launch any mobile games in the near future? Thank you.

Robert Hong Xiao

I think Dota 2 is probably the most famous title in this field and then we think we are pretty honored to work with Valve to launch this in China. We are doing everything we can to make sure this is a success here in China as well as whatever happened around the world. Dota 2 was no doubt that number one game in this field. So we are actually trying our best and I think this is a very important strategy for us to have some partners providing the world class entertainment titles and then sort of provided to our customers here in China.

For the second question on the mobile side, I think mobile is probably growing very fast in the near future and we are really closely looking at it, watching the development and also we do have investment in the mobile space. We do have team developing mobile games not only in China but also outside of China, oversees in different markets as well. But as we understand that this field is still testing water, the entry barrier is pretty low. We are looking for whatever field or subject, developers like us are – can having our advantages and edge. So, I think to summarize the mobile game would be big and mobile applications would be a big thing in the future that’s for sure, and we are proactively joining and watching the development and find the right timing to really jump in more.

Martin Bao – CICC

Thank you very much.

Operator

Thank you. And we go to the next question from Jiong Shao, from Macquarie. Please ask the question.

Jiong Shao - Macquarie

Thanks. I have a couple of questions. Firstly, could you please elaborate a bit on your web game Sword because the game developer (inaudible) and launch plan is a bit different and a much shorter than the traditional, sort of the client-based, MMORPG games? How do you feel that you can leverage or transfer your skill set in the traditional sort of PC games to the web games and do you plan to use a third party website to host your games? Thank you, that's my first question.

Robert Hong Xiao

I think basically we look at few, look at the product from our customer or consumer’s point of view. We are constantly getting feedback from our consumers to understand what people need and we develop certain products for them. So it doesn’t really matter for us what type of game it would be, it really matters if certain group of consumer really need that. So in terms of developing this, our skill set or our advantages are very obvious. We have top of the line artist in our company and we have the best technology background in our company baselines. So by these two we are pretty sure whenever we understand the customer needs we can quickly put up a team and make sure that we use the product to satisfy their needs.

So website, I understand that browser game actually is much quicker, the cycle time is much quicker in terms of development, in terms of launching or even lifecycle but we believe judging from whatever feedback we got from our customers the people really need high quality, long lasting games which can help them to gain certain level of entertainment. Now, the level of entertainment and the way of entertainment people are needing are different. So we – like I said previously we may develop different type of things based on different methodology, mechanism to satisfy people – many people would love to have more time, a longer period of time to invest in a game, to gain the big satisfaction, but many people just have scattered times and try to invest less in terms of time but invest more in getting some instant entertainment. So we have extensive study on this customer behavior and all this and we believe that with our understanding of the consumer, with our technology, with our artistic capabilities, we definitely can do a lot in every space we have.

Now the second question in terms of whether, how we are going to operate our games, or publish our games. We don’t rule out any possibilities because this is in terms of publishing of the browser games is quite different from the traditional MMORPGs. So we don’t rule out any possibilities in collaborating with anybody but at the same time we certainly will do our own publishing at the same time.

Jiong Shao - Macquarie

Okay. A follow up on this, you mention that you have done extensive studies of user behavior; I was just wondering do you consider in your view the web game addressable market as a segment? Is that more incremental or at least partially cannibalizing the traditional sort of time based PC MMORPG games?

Robert Hong Xiao

I think from a technology point of view there’s no major difference. It’s just MMORPG has a bigger clients and the browser game has a smaller client and then the client is so small that you open your web browser and the thing will download it. And actually that thing was highly determined by the -- then was your having in different part of the world. For example, in Korea everybody has more than 10 mb of bandwidth and then a lot of small clients MMO became browser based because the download time is so small. So there’s no – I don’t believe there’s a clear line between the types of different games. And now that comes back to my fundamental issue is like if you have the technology, if you have the capability of designing and putting up great artistic reflections of whatever you want to design. Now, if you truly understand what the consumer needs and find the niche market, you can quickly just put up something for that. So for us the issue is not to clarify what is MMORPG, what is browser based whatever, the key thing for us is to understand deeply understand our consumers to make sure we know how the market has been moving and what type of entertainment people are looking at and then we just utilize our expertise and experiences just build product for them.

Jiong Shao - Macquarie

Okay. Thanks. That's very helpful. My second question is on your deferred revenue. It was down quarter-over-quarter and year-over-year. Could you sort of elaborate a bit on the reasons behind and do you expect it to rebound and when?

Kelvin Wing Kee Lau

The decrease in deferred revenue is because we stopped the some of our income promotion activities in some of our games. So you can see my Q3 revenue for the domestic market stand by about 5% this quarter. So I think we stopped a little bit on the income promotion activities, I think some of the deferred revenue will be realized into as revenue in this quarter. So I think this is the major – and also we didn’t have so many promotion activity and also monetization activity for existing game in China. So the decrease in differed revenue in this quarter is reasonable. We look forward I think I will expect Q4 or in Q1 next year when we do more monetization for our games and into differed revenue. We’ll have some upside as long as we as selling more permanent items in the game I think the differed revenue will go up.

Jiong Shao - Macquarie

Okay. Great. Thank you very much.

Operator

Thank you. (Operator instructions). Your next question comes from the line of Jialong Shi, from CLSA. Please ask the question.

Jialong Shi - CLSA

Hi. Good morning. Thanks for taking my question. My question is purely on Dota 2 but it's a bit more specific. There is no doubt Dota 2 is a very high quality game, but we heard some talk that the game might be difficult to monetize in China because the gameplay is very complicated and it's addressable market is those hard core gamers. On the other hand, there seems to be very few virtual items available for sale in the games, which might suggest a lower ARPU for the game. So could you give some colors on that, thanks?

Robert Hong Xiao

I think the Dota 2 actually – yes, it is a low output game but at the same time we are working closely with Valve because the game is not only for hard core users. The game has not only the value of playing but the value of participating and watching. So if you look at that, there’s a big fan around the world playing but at the same time watching the game, watching other people play. So there are many other ways, non-traditional ways on monetizing in that game and we are proactively working with Valve in terms not only for China but probably for the entire game around the world that finding appropriate monetization ways for this game and no doubt in this world that if you have a great product and a lot of people are paying attention to that or even playing that or watching that, then this is a start or the base for success and we believe in that, that’s why we are joining hands with Valve and it’s probably not a good time to disclose in more details about the operational details for competitive reasons but eventually we are highly confident that together we are going to make this game a great success here in China.

Operator

You may go to the next question from Atul Bagga, from Lazard Capital. Please ask the question.

Atul Bagga - Lazard Capital

Hey guys, thanks for taking my question. I've two questions for you. You guys seem to have a pretty good pipeline of games for next year. I was wondering if you can rank these games in order of your confidence conviction from highest. And also, in terms of the sales and marketing expense for these games, should we expect to see the similar launch expense for these games as we saw for the Return of Condor in the third quarter? And my second question is about your anti-cheating efforts. Hypothetically, if you were to close all the bot accounts, what would be the ACU today? Thank you.

Kelvin Wing Kee Lau

Hey Atul, thanks for your question. Regarding the pipeline, we are confident with all our games. So I think it is difficult for us to rank which one we have more confidence, which one we have less confidence in all our games. As what Robert said, in coming in China we have Swordsman online, we have Saint Seiya. And also we are going to launch Dota 2. In U.S. we are going to launch Neverwinter. I think we have high expectation for all these games. So we are confident all these games can be successful both in China and also in U.S.

In terms of sales and marketing expenses I think we still have adopt the same climate. So before the launch of all these new game, we purchase about RMB 10 to 12 million for I think all the games as well. So I think type of purchase is sufficient enough to cover all those media, I think we need to promote our games. So we’ll still adopt the same strategy.

In terms of anti-cheating effort, I think Atul, as Robert said our policy does not allow me to disclose individual games issue number. As well I said this quarter we adopt a stringent anti-cheating activity for our all game because we really find our issue in -- if we are not going to keep out all those robot I think the gamers will be soft and lift the game. So I think we make a big decision in trying to get away all those gold mining studios and also the robots from Perfect World II especially. So this the major reason for the decline in the issue in Q3.

Unidentified Company Representative

And also the purpose of doing that is to increase the healthy kind of environment for our gamers and basically after this aggressive anti-cheating we’ve kind of reset the bar of issue level to a more two level now. Thanks.

Atul Bagga - Lazard Capital

Very helpful. Very quickly, can you update us on the capital allocation? How should we think about dividend versus buyback versus investments? Thank you.

Kelvin Wing Kee Lau

Dividend policy I think Atul, I mentioned quite a lot of time in the past two quarters. Okay, we obviously adopted a regular dividend policy. I think this regular means anywhere. As well as I said other dividend payment or to pay our (inaudible) will be finally determined by the board. I think at the beginning of next year I will submit a report to the board for review and approval. And also I will keep the market informed okay the how much and when we’ll pay the dividend come year. So I think it is subject to the board approval and also subject to our financial performance and our ability of cash and uses of cash I think in the coming few quarters. Number one share buyback, right now we don’t have any plan on the table to do the share buyback, I think management will consider I think the best use of our cash right now. Thank you, Atul.

Atul Bagga - Lazard Capital

Thank you.

Operator

Thank you. And we go to the next question from William Huang, from Barclays. Please ask the question.

William Huang - Barclays

Hi. Thank you for taking my call. There's two questions. First, about micro client version which is getting popular on the market. Have you started working on that for existing games and how do you view its potential impact on user expansion? And also, in terms of current R&D, what is the typical incentive plan to engineers in the studio, still mainly option driven or revenue share model? And also, quickly housekeeping, what is the total headcounts and R&D accounts in this quarter and if there are any big changes quarter-over-quarter. Thank you.

Robert Hong Xiao

Okay. Thank you for the question. I think like I said a little bit earlier that micro clients is just part of the technologies. I called it technology spectrum because for a bigger serious, deep gains that it requires a bigger client and then for some lighter, small quicker games it requires smaller client and then you can call it micro client and then when it’s small enough you call it the browser base because the thing can be built in from in the browser. So we don’t believe there’s major technology difference and we are trying everything because those same technology are soaring the purpose of building certain products for certain niche market. So we all have all kinds of like we can build big clients, we have engines, everything and we can modify our engines and we are trying similar different types of micro client and we are building broader games actually and then we basically have the same technology platform there. So I don’t believe there’s major difference there and we have a portfolio, our everything almost.

In terms of the R&D incentive plan for competitive reasons I don’t believe this is the right place to disclose in detail but I can say that what we do is we are very competitive in the market, that’s why we have the strongest R&D talents in our company. Our headcount of our R&D has been maintaining more than 2,000 and it has been very stable. We didn’t have any big jump around things, around R&D activity and basically people are very stable, we just focus on doing the best quality games we want to build for our customers.

William Huang - Barclays

Thank you. Very helpful.

Operator

Thank you. And your next question comes from the line Wendy Huang, from CIMB. Please ask the question.

Wendy Huang - CIMB

I apologize first for having actually two questions this time. My first question is you just mentioned that Torchlight sales number actually came above expectation in Q3. Actually in the recent months we have seen several major launches in the global market such as Call of Duty and also World of Warcraft, the new expansion packs. I just wonder how Torchlight's sales number actually compared to those major Western games. And also, your upcoming titles such as Neverwinter and Dota 2, do you expect them to reach a similar user level or revenue scale as Torchlight? My second question is actually more for Michael. Michael (inaudible). Thank you.

Joanne Deng

Wendy, for the rest of the audience benefit, could do you please translate your second question into English as well? Thank you.

Wendy Huang - CIMB

Sure. My second question is for Michael. I just wonder in the past many years I think Perfect world has been quite good at marketing and also we're known for the fast development cycle. I just wonder if these competitive advantage or unique trends are still there. If not, how will Perfect World look for the new competitive advantage or niche in the domestic market? Thank you.

Robert Hong Xiao

Thank you Wendy for the question and I’ll try to answer your first question first. Torchlight 2 is a little bit steamy, a little bit surprise for us because we knew it was a great game. The quality of the game was top of the line and of course we don’t openly compare with our competitors, we don’t have any reliable data from our competitors but we know that out of this market Torchlight 2 has been a great game. But still the sales numbers came in a little bit surprising because it was so good. And of course one of the reasons that as we know that Torchlight 1 was a successive game and it came in at Torchlight 2 was even more successful that touch light 1.

So of course we expect our new games to be as successful as we hope our new games would be as successful as the Torchlight 2 and we are putting a lot of effort on the Neverwinter for example in the U.S. but of course because Neverwinter and Torchlight 2, two different type of games, two different kind of market and it’s probably pretty hard to compare, so we are not going to do any comparison and then in terms of actual numbers, anticipation or expected numbers for Neverwinter, Dota 2, it is too early for us to comment at this point on time. So, but again we believe in running this business we figure that what we want to do is just to put every bit of the greatest effort we have into this and then we have a good chance to be successful. So that is exactly what we are doing now and I’ll pass the second question to Michael.

Michael Chi

(Inaudible)

Vivien Wang

Regarding about our core advantages. I think that in addition to our core competitive advantage in our China operational capabilities as well as our quick development cycle, our R&D capabilities in also our key competitive advantages. Actually back in 2005 and 2006 we have developed our 3D engines which give us the leading technologies edges in the industry and I just think we still have those four competitive advantages in R&D capabilities. The only difference is that before there were not so much specialized 3D developers in China. So I think going forward we would be more focused on developing this high quality games and we will be more focused on data studies and user experience when we develop our new games. You can see that we have invested quite a lot in R&D and that’s because we want to focus for our long term healthy growth for our business. So we do believe that we can deliver more high quality games in the future. Thanks.

Wendy Huang - CIMB

Thank you everyone for answering and translating my questions.

Operator

Thank you. There are no further questions at this point in time. I’ll now like to turn the call back to Ms. Joanne Deng for closing remarks.

Joanne Deng

Thank you. This is the end of the conference call. The webcast replay will be available at Perfect World's official website www.pwrd.com under IR section. If you have additional questions please feel free to contact us.

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