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NetEase, Inc. (NASDAQ:NTES)

Q1 2006 Earnings Conference Call

May 16, 2006 8:00 p.m. EST

Executives

Brandi Piacente - IR

William Ding - CEO

Michael Tong - COO

Denny Lee - CFO

Analysts

Lu Sun - Lehman Brothers

Wallace Cheung - Credit Suisse First Boston

Richard Ji - Morgan Stanley

Safa Rashtchy - Piper Jaffray

Frank Shi - CLSA Limited

James Mitchell - Goldman Sachs

Dick Wei - JP Morgan

Jason Brueschke - Citigroup

William Bean - Deutsche Bank

Antonio Tanbunan - Bear Stearns

Tian Hou - C.E. Unterberg

Ming Zhao - Susquehanna Financial Group

Presentation

Operator

Good day and welcome to NetEase first quarter 2006 financial results conference call. As a reminder, today's call is being recorded. For opening remarks and introductions, I would now like to turn the call over to Ms. Brandi Piacente. Please go ahead.

Brandi Piacente

Thank you, operator. Today you will first hear from Mr. Denny Lee on behalf of Mr. William Ding, Chief Executive Officer, who will discuss some of the highlights for the quarter ending March 31, 2006. Next will be Mr. Michael Tong, Chief Operating Officer, who will review our online game business. Finally, Mr. Denny Lee, Chief Financial Officer, will review the financials.

Before we continue, please note that the discussion today will contain forward-looking statements relating to future performance of the Company and are intended to qualify for the Safe Harbor 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.

Risks related to the fluctuation in the value of the renminbi with respect to other currencies could also adversely affect the Company's business and financial results. The Company does not undertake any obligation to update this forward-looking information, except as required by law.

As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on the NetEase corporate website at corp.netease.com. I will now turn the conference call over to Mr. Denny Lee, who will read the remarks on behalf of Mr. William Ding, Chief Executive Officer of NetEase.

Denny Lee for William Ding

Thank you, Brandi. Hello, everyone and thank you for joining us. Total gross revenues for the first quarter increased 8.7% over the prior quarter, and 61.7% over the first quarter of 2005.

Our online games business, which accounts for approximately 85% of our total business continued to outpace the industry, with total gross revenues growing more than 71.9% from the same period in 2005. First quarter online game revenue exceeded guidance, and grew 12.4% over the fourth quarter of 2005 and 71.9% over the same period a year earlier.

Total gross margin of our online game business has remained strong, at approximately 90.7%. During the first quarter, Fantasy Westward Journey, which remains the number one game in China two years after its initial launch in 2004, achieved approximately 1.3 million peak concurrent users and posted double-digit growth in revenues.

Turning now to our new game pipeline. Currently, both our 2.5D and 3D games are in various stages of beta testing. Datang, our 2.5D game, is under external closed beta; and Tianxia, our 3D game, is under internal closed beta. We expect Datang to open beta testing by May 31, 2006; and Tianxia to enter open beta testing in the second half of 2006.

In addition, we have begun to execute on many initiatives for our online advertising business. As one of the leading Internet portals in China, we will be making a big push in 2006 in maintaining our leadership position in this business.

Let me now turn to Michael who will provide an overview of our business for the quarter.

Michael Tong

Thank you, Denny and hello, everyone. I will now provide a more detailed overview of our business for the quarter. Overall, we are pleased with our progress in our online game business in the first quarter. Total revenues for this business grew 12.4% quarter-over-quarter and 71.9% year-over-year, driven by double-digit revenue growth of Fantasy Westward Journey.

While we did see some declines in revenues for Westward Journey Online II, this four-year-old game continues to remain among the top three most popular games in China. As Denny mentioned, Fantasy Westward Journey grew to approximately 1.3 million peak concurrent users in the March quarter, the games highest PCU level since it was released in 2004, and the highest number of peak concurrent users in the entire MMORPG markets in China.

We are pleased to see that Fantasy Westward Journey grew by 22% in revenues during the quarter, although our expectation was higher. Westward Journey Online II revenues declined slightly by 4%, but continues to remain the third-most popular online game in China, after more than three years.

In view of the current market popularity and success of our two in-house developed games, we continue to focus more resources on developing better and more comprehensive expansion packs, and new content for Westward Journey II and Fantasy Westward Journey to take advantage of the growing strength and nationwide popularity of these games.

With respect to our Advertising business, total revenues for this business decreased 10.9% quarter-over-quarter and grew by 36% year-over-year to $7.7 million, maintaining similar market share compared to previous quarters. We continue to build our portal and advertising business through the addition of new content and services for our Internet users.

On the application side, NetEase continues to maintain its leadership position in free email, and we will continue to innovate on monetizing its users. As for content, we have since last year been working more closely with major vertical portals such as China Finance Online and Sofun.

During the first quarter, we have added another vertical partner as we enter into a new cooperation with Mango City, to view content in coordination with our Company's efforts to develop our travel channel. Let me now turn the call over to Denny who will go into more detail on the numbers for the first quarter of 2006.

Denny Lee

Thank you, Michael. I will now go through some of the key highlights for the quarter. Please note that in order to provide a more meaningful comparison of NetEase's current operating results, [the are tied] to the Company's adoption of FAS123-R, which took effect this year. In some cases, we are providing non-GAAP results from the first quarter. A reconciliation of NetEase non-GAAP financial measures are provided in the unaudited financial information included in today's earning release.

First quarter total gross revenue increased to 8.7% from the preceding quarter, and 61.7% over last year's first quarter to $66.1 million. First quarter gross revenue in our online games business was better than the Company's guidance, and increased 12.4% sequentially and 71.9% year-over-year to $56.2 million.

Advertising services revenue decreased by 10.9% quarter-over-quarter, and increased 36% year-over-year, to $7.7 million in the quarter ended March 31, 2006. The quarter-over-quarter decrease in revenue was due to the seasonal impact, as certain advertisers decreased their spending during the first quarter.

Value-added services and other revenues increased 2.3% quarter-over-quarter and decreased 13% year-over-year to $2.2 million in the first quarter of 2006. We believe the wireless value-added services market is still subject to ongoing restructuring of the industry.

Our overall GAAP gross margins in the first quarter were 82.7%. However, because of the Company's first time adoption of FAS 123-R, which took effect this year, it will be more meaningful to compare non-GAAP gross margins to the prior period.

Our non-GAAP gross margin for the online game business increased slightly at 90.7% for the first quarter, compared to 89.4% in the prior quarter, and 89% for the first quarter of 2005, primarily due to the termination of revenue sharing arrangements with spokespersons for Fantasy Westward Journey and Westward Journey Online II in November, 2005.

Non-GAAP gross margin in our advertising business declined to 55.3% in the first quarter, primarily as a result of a seasonal decline in spending by certain advertisers during the first quarter of 2006.

Non-GAAP gross revenue for wireless value-added and other customers declined in comparison to the preceding quarter, and the same quarter a year ago due to increased server depreciation costs associated with the costs associated with the Company's free email services.

Total GAAP operating expenses for the first quarter of 2006 were $14.2 million, and total non-GAAP operating expenses for the first quarter of 2006 were $11.5 million, compared with non-GAAP operating expenses of $11.8 million for the preceding quarter; and $10.9 million for the same period last year. The decline in non-GAAP operating expenses were primarily the result of lower G&A expenses resulting from the decrease in the provision for bad and doubtful debt expenses; due mainly to the settlement of certain long-term debt.

We continue to carefully manage our expenses and operate to achieve solid financial results during the quarter. As a result, we reported another solid quarter of both sequential and year-over-year net profit growth. Recording GAAP net profit of $36.6 million and non-GAAP net profit of $39.9 million, which represents a 15.5% percent increase over previous quarters non-GAAP net profit of $34.3 million and 107.7% increase over non-GAAP net profit of $18.6 million for the first quarter of 2005.

The Company reported GAAP basic and diluted earnings per ADF of $0.28 and $0.26 respectively, which includes the impact of approximately $3.3 million, or $0.02 per ADS in non-cash, share-based compensation costs. Non-GAAP diluted EPS was $0.28 for the first quarter of this year.

As of the 31st of March, 2006 our combined total cash and deposit balance was $469.8 million, and we reported a positive upgrade in cash flow of $51.4 million for the first quarter of this year.

Now, I would like to read to you our financial guidance for the second quarter of this year. Please note that the following outlook statements are based on our current expectations, and these statements are forward-looking, and actual results may differ materially.

We expect the total gross revenue of the Company in the second quarter of this year will be between $59 million and $70.5 million, with online game services revenue to increase by 4% to 6% quarter-over-quarter. Advertising services revenue to increase by 12% to 14% quarter-over-quarter, and wireless, value-added and other revenues to be flat or a decrease of 5% quarter-over-quarter. Net profit during the second quarter is expected to be between $38.5 million and $39.8 million.

These estimates include the effect of share-based compensation expenses of approximately $3.2 million. Please note that such share-based compensation expenses are only our best estimate as of today, and the actual expense may differ from the estimate. Also we caution that we cannot predict the future exchange rate of renminbi versus other currencies, and therefore cannot accurately estimate the effect of any changes in exchange rates on our financial results. Accordingly, our guidance assumes no change in exchange rates in the second quarter in 2006, and has afforded the same exchange rate as of the 31st of March, 2006 of $1 to RMB8.0167. Our actual results could differ, however, from our guidance as a result of fluctuation in the RMB exchange rates.

Finally, on behalf of William, he would like to thank everyone for joining us today. He would also like to make a brief comment about NetEase's newest addition to the Company's senior management team.

As mentioned in today's press release, Zhonghui Zhan has been with NetEase for over nine years, and has recently been appointed to Co-COO. Mr. Zhan will primarily be in charge of overseeing the Company's online game operations, and Michael Tong, the Company's existing COO, will now turn his focus to build our NetEase portal and advertising business, which is a major initiative for the Company in 2006.

With Michael's existing track record in successfully growing the Company's online game business, combined with his profound knowledge of the Company, Michael is the ideal person to build a dominant position in the portal and advertising markets.

Management believes 2006 will be an exciting year for NetEase, and we look forward to showing you continued progress as we execute on our growth initiatives. We would now be happy to take your questions. Operator, please open the floor for Q&A.

Question-and-Answer Period

Operator

(Operator Instructions) Our first question comes from Lu Sun - Lehman Brothers.

Lu Sun - Lehman Brothers

Good morning, everyone and congratulations on a great quarter. I actually have two questions. One is regarding your new game pipeline. Can you explain to us why there is a delay in the launch of Datang's open beta? What are your expectations for this game when you launch it before the end of May?

The second question is on your advertising business. You mentioned that you will focus a lot more on this business in 2006. What is your growth outlook, and what are the new initiatives to really drive this business in comparison with your competitors? Thank you.

Michael Tong

For Datang we are going to enter the open beta on the 31st of May, this month. I think this is basically in line with what we have said before where we mentioned Spring 2006 for the open beta of Datang. I think there is a slight delay in that, but I think it is because we simply wanted to add more content; to launch a more comprehensive game.

For Tianxia we are going to launch this game in the second half of this year. It is actually for similar reasons, that we want to add more content and make sure that the game is very comprehensive when we launch.

For the advertising business, I am sorry we cannot give an official growth outlook on the numbers, but I think I addressed this question to the investors and analysts before, that we are confident that we will try to grow at least in line with the market.

Also, in terms of how we differentiate between our advertising business and the others, I think we have two parts of our strategy. One is on the application side, and the other is on the news and other general content. Where, on the application side we continue to build up different kinds of services, like the email. We are number one, in the leadership position compared to other competitors, which is very unique when compared to other portals.

Lu Sun - Lehman Brothers

Can I just have one final follow-up? Regarding your margin trend, certainly this quarter is very impressive. Going into the second and third quarter, would you expect that the operating margin will be slightly lower, because you have to spend more to promote your new games, and also launch new applications on the portals?

Denny Lee

In the first quarter of 2006, the margins are really very impressive, in particular for our online games. The gross margin was higher than 90%, which is actually even higher than the fourth quarter and also the first quarter of last year. The main reason for that is we have, as mentioned in our press release, we have terminated revenue sharing arrangements with certain spokespersons for both of our titles, which saves us some cost. This is ongoing, and not just one time.

So the gross margin for that online game business will likely remain 90% or approximately the high 80% range going forward. With the additions of new titles and with the revenue contributions becoming more in the later part of the year when the new titles are up and running, there may be some slight impact on the margins. I don't expect that the margin impact will be very significant, because of the economies of scale, obviously.

On the other business segment line, online advertising, you can see some slight improvement in our margin this quarter. Going forward, because the second and the first quarter will be our high season for online advertising, whereas the costs are relatively stable then we expect that there will also be improvement in our gross margin in our online games and our portal.

For wireless and other, the negative gross margin is actually because of our continuous investment in our email systems. We continue to invest in that area, because we see that as one of our strengths of our portal. The margin will continue to be negative going forward, if the wireless business is not recovered on the revenue side.

On the operating expenses side, you are right in saying that when we are launching our new cycles there will be increased marketing expenses, but we don't expect that we will spend a huge amount of money on the marketing of new titles, in particular because our new titles are already well-received in the market. We will do reasonable efforts to market our games. However, because of these growing revenues, then the percentage of the marketing expenses, as a percentage of net revenue, will not increase significantly.

For G&A expenses, because it is more amortization of the expenses which we incurred for the full year, then it will be more likely to stay flat. As a percentage of the net revenue, it will have some leverage.

R&D is the area that we definitely want to increase our efforts and also increase our spending there in terms of increasing our head count and also to remunerate our R&D people better. So going forward we expect that R&D expenses will increase in both the absolute terms and also in terms of net profit percentage.

So all in all, we are saying that we will be able to maintain our reasonably high operating profit margins.

Lu Sun - Lehman Brothers

Thanks very much, and congratulations again.

Michael Tong

Thank you.

Operator

Our next question comes from Wallace Cheung - Credit Suisse First Boston.

Wallace Cheung - Credit Suisse First Boston

Congratulations Michael and Denny on the great quarter. My question is very short. Actually in your second quarter, have you factored in any incremental revenue from potentially Datang? If not, should we expect that incremental revenue can come in the third quarter? Thank you.

Michael Tong

No, we have not factored any revenue from Datang in the second quarter. I am sorry that we cannot give you an exact date on the open beta yet.

Wallace Cheung - Credit Suisse First Boston

My follow-up question would be, in such a case in the online gaming business, guidance of 46% quarter-on-quarter growth; should we expect the majority of the growth actually coming from Fantasy Westward Journey?

Michael Tong

I think we can give you a bit more details on this. Fantasy Westward Journey growth will be on the upper side of single digits. Westward Journey Online II will be flat.

Denny Lee

Let me supplement a little bit on that projection. As you can see in the last quarter, the sequential growth on the online game revenues, the mix is that approximately a low percentage, 5% is coming from Westward Journey II. About the high single-digit percentage growth is coming from Fantasy Westward Journey, which is a newer game.

Whereas in Q4 over Q1 in the past quarter, the increase in revenue was mainly coming from Fantasy Westward Journey in which we saw more than 22% growth in revenue. Whereas for Westward Journey, which is our older title, we saw actually a decline in revenues sequentially by around 4%.

However, when we are giving our guidance for the second quarter in 2006, the situation has changed a little bit because first, the Westward Journey Online II, because of the expansion pack impact -- we launched an expansion pack earlier this year. We start seeing the impact. We are projecting a flat quarter in the second quarter for Westward Journey II.

Whereas for Fantasy Westward Journey, we are actually projecting high single-digit growth for that in the second quarter. I hope that makes you clearer on the mix of the revenue growth.

Wallace Cheung - Credit Suisse First Boston

Very clear. Thanks so much and congratulations.

Operator

We will take our next question from Richard Ji - Morgan Stanley.

Richard Ji - Morgan Stanley

Hi, Michael and Denny. A good quarter. I have two questions. The first question is regarding your portal. We know you made some progress in striking a third-party content alliance with Sofun and most recently, Mango. Your traffic is clearly up. [inaudible]. Can you just elaborate a little more going forward, how are you going to leverage your portal spend for revenue growth?

Michael Tong

Richard, I think the first thing is still advertising revenues, definitely. It is just a proven way of monetizing the portals. Also, as Lee mentioned, how we differentiate, besides the normal content of news or finance, we continue to have different kinds of applications. Email is one of our hero products.

Recently we have the very popular product called Photo Sharing, which is also a very popular product. We will maintain and continue to build different kinds of services for the Internet users. Not just on general content, but also on different kinds of services with our technologies and so on.

The first way is, of course, advertising. Going forward we need to see the possibility of premium services, paid services. Obviously there will be a lot more results.

Richard Ji - Morgan Stanley

Another related question is about the R&D initiative. Clearly, we were impressed by your high margin, but we also want to see you invest for the future. Can you just give us a little more color on what are the particular areas that would be major priorities for the next 12 to 24 months?

William Ding

Hello, Richard.

Richard Ji - Morgan Stanley

William, hello.

William Ding

[Response in Mandarin]

Michael Tong

Let me translate. On the advertising, on monetizing the portal the one thing that we point out is that in terms of traffic, I think we are very similar to the other portals like our major competitors. I think that our rate of monetization is not as good as the others. We would focus on bringing up this rate of monetizing our users.

In terms of the R&D, we have been recruiting a lot of very talented programmers and engineers to develop different kinds of new services and products. Of course, that would include technologies in the advertising, the traffic system; different kinds of new services and products that we are going to launch. We will be announcing later on in the second half of the year for the portal as well.

Richard Ji - Morgan Stanley

Thank you.

Operator

Our next question comes from Safa Rashtchy - Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Good morning, William, Michael and Denny. Good quarter, congratulations. I had a question on your games, both the existing ones and the upcoming ones. First, on existing ones, it appears that Fantasy is continuing to grow and there is no sign that it is reaching the top. I would like to know if you share that view, or if it has been helped by the expansion packs.

In other words, if you could give us your assessment of where Fantasy is, as well as what should we expect for Westward Journey II? I had a quick follow-up on the new games, please.

Michael Tong

Safa, this is Michael.

Safa Rashtchy - Piper Jaffray

Hi, Michael.

Michael Tong

Fantasy Westward Journey, we are going to have the next expansion pack, which is actually already launched just today. This new expansion pack is an expansion pack where users in different servers can play together in one special place and they can have a huge competition and huge warfare. This is new for Fantasy Westward Journey. We have done similar expansion packs for Westward Journey II before, and the results were quite good.

I want to remind you that usually the expansion packs results do not impact very quickly. It might actually impact later on in the one-month time, or so, in terms of the revenue growth for this game.

Asking about limits for Fantasy Westward Journey, frankly we don't know. I think we are very confident to see the game continue to grow in the next two quarters or so.

Then for Westward Journey II, I think Denny also explained, although the game decreased by 4% this quarter compared to last quarter, we are actually seeing a flat quarter in the second quarter of this year for Westward Journey II. That is mainly because we feel that the expansion packs that we have launched in the middle of the first quarter is taking effect actually much later in the second quarter, and that is why we are seeing a flat quarter.

Given that the game has been running for more than 3.5 years, I think it is already a very spectacular business for Westward Journey II. We are kind of in the peak, or what we have mentioned before, kind of a plateau period for Westward Journey II right now.

Safa Rashtchy - Piper Jaffray

On the upcoming games, you have been testing them for quite some time. I think, as you can sense, investors are quite anxious to see when they will finally come out to open beta and then to the commercial launch. Can you give us some color as to what you are finding with the internal closed beta? What are your expectations based on the trials that you have seen so far? To what degree have you modified the games? Just give us some color as to what your outlook on the game has changed during these trial times?

Michael Tong

For Datang, the open beta is going to be the 31st of May, this month, two weeks later. And then for Tianxia the open beta, we haven't decided yet but it will be obviously in the second half of this year.

Then in terms of the commercial launch, again historically we spend between one to three months time for the open beta, between open beta and commercial launch. I think we will be able to achieve a similar period of time for these new games.

In terms of expectations, again we are sorry that we cannot give any numbers on that. But for Datang, which is a 2.5D game, obviously we will be targeting more towards inland cities where their computer hardware configuration is much lower. Tianxia will be targeted more towards the coastal cities where they have better hardware to run the 3D games.

Again, these two games are not socially oriented, which we did not see much cannibalization between the current games that we have. Other than that I think I won't be able to give you more in terms of color on the numbers on the expectations of the open beta or the commercial launch.

Safa Rashtchy - Piper Jaffray

Okay, thank you.

Operator

Our next question comes from Frank Shi - CLSA Limited.

Frank Shi - CLSA Limited

Congrats on good results. Can you talk about the market share in the common games market? Do you see the market increasingly concentrated on the top games? Also, are you developing a new game at this time? Thank you.

Michael Tong

Frank, this is Michael. In terms of the market share of the online game business right now, I think it was very easy to calculate because there used to be a lot of MMRPG games, and picking up the majority of the market share. So we are able to calculate between Shanda, ourselves, [Ninetowns] in terms of the market share that we have. But it is getting more and more difficult, frankly, because we are seeing more casual games coming out which are also making money in the market share right now.

It used to be we just calculate the market of those listed companies, but we are seeing more and more unlisted companies where they have shown their numbers in some press release, and so on. So it is getting more and more difficult to calculate exactly what the percentage is that we have, in terms of the market right now.

We can calculate in terms of MMRPG. Does that answer your question?

Frank Shi - CLSA Limited

I was wondering whether the market is more concentrated on the top -- you, [Ninetowns], the top MMRPG games?

Michael Tong

The market continues to concentrate on the MMRPG like ourselves. We are definitely seeing more and more of the games coming out, some by non-listed companies like -- I want to mention like Freestyle. They seem to be making quite a bit of money as well.

It is just more difficult right now. I think it is still a little bit more concentrated, in terms of the top five players continue to have more than 70% of the market.

Frank Shi - CLSA Limited

Thank you. Since we are talking about casual games, when do we expect NetEase to generate meaningful revenues from casual games?

Michael Tong

I think right now, for '06 I think the priorities for us is to continue to launch the two games, Datang and Tianxia. I think within 2006 we will not see any material revenue coming from the casual games. I think it would be on the agenda for 2007.

Frank Shi - CLSA Limited

Thanks. I assume you are also developing new MMRPG's, right?

Michael Tong

Yes, of course.

Frank Shi - CLSA Limited

Thank you.

Operator

Our next question comes from James Mitchell - Goldman Sachs.

James Mitchell - Goldman Sachs

Hi, good morning. Could you break out the average concurrent users for each game by month for the quarter?

Michael Tong

Yes, of course. Average concurrent uses for Westward Journey II in January, is 200,000; in February, 205,000; in March, 198,000. Then for Fantasy Westward Journey, in January, is 444,000; in February, 478,000; and in March, 453,000.

Operator

We will take our next question from Dick Wei from JP Morgan.

Dick Wei - JP Morgan

Congratulations on the quarter. I just want to ask if you can let us know what is the expansion pack for the existing games, a further schedule for that? Also, as Frank asked a question about upcoming games, if you can give us expectation or schedules for the new games, that would be great.

Michael Tong

Yes, the expansion pack for Fantasy Westward Journey has just been launched within these two days. In fact, it is across our server, kind of a warfare, something like that. It is a new kind of expansion pack for Fantasy Westward Journey because it used to be more concentrated on the social and communications. Now we have a little bit, give it a little bit more competition within the games for players. We hope it will attract more new kinds of users for the games.

Then for Westward Journey Online II, it should be around August of this year. I do not have much information right now for what types of facilities for the expansion pack yet.

Then, for the other new games that we are developing now, of course, there will be Westward Journey III and one other game that we are developing right now, which we are targeting an ’07 launch. I think it is too preliminary to explain the exact timing, and also the details of this game, but that is the plan right now.

Dick Wei - JP Morgan

So is it both Westward Journey III and the other game that are without a launch?

Michael Tong

I am sorry?

Dick Wei - JP Morgan

Is it Westward Journey III is also in 2007, a different schedule?

Michael Tong

Yes, it is just very preliminary, but there is no exact timing right now.

Dick Wei - JP Morgan

All right. On Westward Journey II, is the new engine going to be launched for the end of the year as well?

Michael Tong

Yes, that is right. There will be a new engine for Westward Journey II, as we have explained before.

Dick Wei - JP Morgan

Thank you.

Operator

We’ll take our next question from Jason Brueschke from Citigroup.

Jason Brueschke - Citigroup

Thank you. My two questions are first of all, it seems that a one to three-month open beta launch for your new games, it strikes me as slightly long, considering how long you have been in closed beta and working on these games. Could you maybe comment on what you hope to achieve, if you end up doing a two or three month open beta? Why the necessity for that?

The second question is, could you maybe give us an update on what your planned use is for your cash? You have an enormous amount of cash. Are you thinking about a dividend or any M&A on the horizon? Thank you.

Michael Tong

Yes, I think we do not have much to comment on the one to three-month, if it short or long. If it is one month, it is short. If it is three months, it is long. But I think we just say it is one to three months generally, that is also our experience before.

I think for the next question, in terms of cash that we have.

Denny Lee

For the cash, we have always been evaluating the best use of the cash, for again re-purchase and also dividend and [inaudible], because there is no free position yet.

On M&A it is less likely, because in the past, we tried to grow our business organically, instead of acquiring companies. We do not expect to use so much cash in doing M&A.

Jason Brueschke - Citigroup

Thank you.

Operator

Moving on to our next question from William Bean, Deutsche Bank.

William Bean - Deutsche Bank

Thanks, guys. I just wanted to get a sense of Fantasy Westward Journey, whether you know where your stream of new users come from, or the growth? Is it just people playing longer hours or coming back with the expansion packs, or are you actually seeing a lot of new users signing up?

Michael Tong

In terms of the new users, we are actually seeing a lot of new users coming for first time every month and every day, and these new users, part of them would be new users in the market that have not played any games before. It could be new users that have left the game maybe one year ago and then come back for expansion pack. We usually call that flow back users, but not really new users.

It does not mean that the users played longer hours or spend more money on games. In terms of the ARPU or average spend per user, it has been very, very stable, and it is still around 40 hours or so per month.

William Bean - Deutsche Bank

Can you give a breakdown of the new versus the returns?

Michael Tong

I would say the new and the returning is somewhere around one to two, so out of every three users, there are two new users and one comeback user.

William Bean - Deutsche Bank

This is a real stupid question, I guess, but looking at, you are saying the new games, the market believes that they will be very well-received. Is there some specific poll or article or place that we can look to get a sense of just how well-received it will be? What gives you that impression that the new games will be well-received in the market?

Michael Tong

The easiest thing to do is to look at the bulletin boards within our games.

William Bean - Deutsche Bank

Okay, so you are not talking about any specific sort of newspaper poll or something like that, it’s just buzz on the boards?

Michael Tong

Actually, I think it is the most objective way to look at it.

William Bean - Deutsche Bank

Okay. Thank you.

Operator

We will take our next question from Antonio Tanbunan from Bear Stearns.

Antonio Tanbunan - Bear Stearns

Hello, congratulations on the quarter. I just have a couple of short questions. Michael, I just want to double-check; did you say that the March AC was 453,000 or 463,000?

Michael Tong

453,000.

Antonio Tanbunan - Bear Stearns

You guys mentioned stability of the ARPU growth. Was there any increase, even a slight increase, from last quarter in terms of the ARPU?

Michael Tong

ARPU has been very stable.

Antonio Tanbunan - Bear Stearns

So we have not seen any increase at all, right?

Michael Tong

No.

Antonio Tanbunan - Bear Stearns

You said you have a huge initiative for ’06, and expanding your new function on the portal business. Does that mean we are expecting something -- I mean, we are not expecting something that you did back in 2004, right, where you have a huge summer blow-out advertising campaign -- right?

Michael Tong

Yes, there will be more funds coming out for the portal, and also we will spend a bit on the marketing side. It is not going to affect our financial, in terms of the percentage of the marketing costs, much.

Denny Lee

Let me add on to that. The campaign that we did in 2004, it was different from the normal product marketing. It was the 163.com that we very seldom use. We only do it once every three or four years. In this year, I think there will be a lot of new products launched, and the marketing expenses will jump like the case that we did in 2004.

Antonio Tanbunan - Bear Stearns

Okay, that is pretty much about it. Thank you very much.

Operator

We will take our next question from Tian Hou, C.E. Unterberg.

Tian Hou - C.E. Unterberg

Hi, Michael, Denny, and William. This is Tian. The question is really related to your prepaid card distribution system. Can you give me some color on that? Are there any changes in the past quarter in terms of your distribution strategy?

Michael Tong

Tian, I guess part of your question is on the distribution platform, is there any change in 2006 for our point card?

Tian Hou - C.E. Unterberg

I think the question really comes from one instance regarding your R&D.

Denny Lee

It looks to me like it is a very simple question -- will there be any changes in our distribution platform?

Tian Hou - C.E. Unterberg

Have you changed it, or are you going to change it, yes.

Michael Tong

Very fine question. I think we have been having this distribution platform for our point cards for a very long time, and in different ways. First, when there are new ways to distribute more, of course we will find new ways. But I am sorry, I do not really understand the question, actually.

Tian Hou - C.E. Unterberg

[Question in Mandarin]

You are going to do something else, your electronic distribution system. So that is where the question comes from.

Michael Tong

Actually, when we raised the point card for the 50 points point card price, there were some distributors that mentioned what they do not like about it. The way look at it, everything just goes back to normal and everything goes back to normal and the way they distribute the cards and so on.

We have been tracking this every day, every week, and it has no effect on distributors not wanting to distribute our cards more, actually.

Tian Hou - C.E. Unterberg

Okay. Thank you. The other question is really related to a new operating model, which is imposed by Shanda. Lately, they licensed their game at a regional level and this sort of wholesale, bare games. Do you see that as something that could potentially give you impact in the future?

Michael Tong

I think it is just a different way of distributing a game. It is a new way, but I do not think that we would like to imitate. Also, we do not think it is something that is -- it is not affecting us.

Tian Hou - C.E. Unterberg

Okay, thank you.

Operator

We have time for one more question, from Ming Zhao, SFG.

Ming Zhao - Susquehanna Financial Group

Thank you very much, and good morning, guys. I want to ask a question on the advertising side, maybe a few small questions. First, since your competitors gave year-over-year gross on the advertising, I wonder if you could also provide the same color on your advertising, in year-over-year terms.

I think maybe more detail even, for the rest of Q3, you have a surge in the advertising revenue quarter over quarter. Are we going to see the same kind of thing in this Q3?

Lastly, on the search side, could you give us some breakdown in terms of percentage. What is the percentage of your advertising revenues from search, which your partner was Google. Do you see growth very good over there? Thank you.

Michael Tong

Why don’t we just focus on the search question, because I am sorry, we do not have time to answer all the questions, but let’s focus on the search one. In terms of the search, the quarter-over-quarter increase for the search revenue is actually a bit of a decrease, and it is actually, the composition of the search decreased from 12% in terms of the overall online advertising to 10% right now. I think that is due to a bit of, obviously more competition from Baidu and also from Google, who are operating more in China right now.

Then right now, we also, of course, we are partnering with Google in terms of the search, which we have explained before. Other than that, we cannot give you a kind of a year expectation on the search market because we are still a very small player and I do not think it is appropriate for us to give you a search market overview.

Ming Zhao - Susquehanna Financial Group

How about on the branded advertising side? Could you give us the year-over-year growth rate?

Denny Lee

Ming, I think on the year-over-year guidance, we never give out full year guidance, but we have been talking to already investors, analysts, that we are comfortable that we will be doing a leap as the market growth rate, and we can see from the trend in the first quarter that we, actually compared year-over-year, it was about 36% year-over-year growth. The second and the first quarter will be [inaudible].

Ming Zhao - Susquehanna Financial Group

Thank you very much.

Operator

At this time, I would like to turn the call over to Brandi Piacente for closing remarks or additional remarks.

Brandi Piacente

Again, thank you for joining us today. Please feel free to contact us if you have any further questions. Have a good day.

Operator

That does conclude today’s conference call. We thank you all for joining us. At this time, you may now disconnect.

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Source: NetEase, Inc. Q1 2006 Earnings Conference Call Transcript (NTES)
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