Shanda Interactive Entertainment Ltd Q1 2006 Earnings Conference Call Transcript (SNDA)

May.18.06 | About: Shanda Interactive (SNDA)

Shanda Interactive Entertainment Ltd (NASDAQ:SNDA)

Q1 2006 Earnings Conference Call

May 17 2006, 9:00 pm EST

Executives

Donglei Zhou - Director of Business Development & IR

Tianqiao Chen - CEO

Jun Tang - President

Shujun Li - CFO

Daniel Zhang - Financial Controller

Analysts

Safa Rashtchy - Piper Jaffray

James Mitchell - Goldman Sachs

Wallace Cheung - CSFB

Antonio Tambunan - Bear Stearns

Dick Wei - JP Morgan

Chang Qiu - Forun Technologies

Operator

Welcome to today's Shanda Interactive Entertainment first quarter 2006 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Donglei Zhou, Shanda's Director of Business Development and Investor Relations. Donglei, you may begin.

Donglei Zhou

Thank you, operator and welcome everyone to Shanda’s first quarter 2006 conference call. I would also like to give a special thanks to our friends in the U.S. who joined this call at a later hour. As always, we appreciate your participation.

With us today on the call are Tianqiao Chen, our CEO; Jun Tang, our President; and Shujun Li, our CFO and Daniel Zhang, our Financial Controller.

After the close of the U.S. market today, Shanda issued its first quarter earnings release. Copies of the release have been sent to you for your information and reference during this call. A copy of the release is also available on Shanda’s corporate website at www.snda.com.

The purpose of this call is to provide investors with some further details regarding our financial results and to provide a general update on the Company. Following our formal remarks, we’ll be happy to take any questions you might have.

Before we begin, I would also like to remind you that during today’s call we will make certain forward-looking statements that are intended to qualify for the Safe Harbor from liability for such statements established in the U.S. Private Securities Litigation Reform Act of 1995. All statements during the conference call, other than statements of historical fact, are forward-looking statements.

Although we believe that our expectations expressed in our forward-looking statements are reasonable, we cannot assure you that our expectations will be correct. Risks and uncertainties could cause our actual results to be materially different from our expectations, including the risks set forth in our filings in the U.S. Security and Exchange Commission. Now with that, I would like to turn the call over to our CEO, Tianqiao Chen.

Tianqiao Chen

Thank you, Donglei and welcome everyone to Shanda's first quarter conference call. Our first quarter 2006 financial results demonstrate that we have successfully executed a key transition in our core business. Revenues from online games have stabilized after we introduced free to play and item-based revenue model for three of our leading MMORPG in December last year.

We have also continued to make good progress in the roll out of our EZ Pod product as we focus on developing key business partnerships. Overall, this is a good start to the year.

Let me start with our core online game business. We are quite pleased with the performance of our MMORPGs in the first quarter, especially since this is the first full quarter operating under an item-based revenue model.

With such a significant change in the first quarter, the games operated under the item-based revenue model contributed 97.3% to our total online game revenues. Our MMORPG revenues were able to achieve 67.6% of the last quarter's level.

At the same time, we also witnessed considerable user growth in the monetization trend. This is a strong presentation of our belief that the item-based e-commerce revenue model would best address the needs of our customers and that this is an industry trend that we should work with, instead of against. We will continue with the implementation and the optimization of this model in our existing games, as well as in our future games such as ArchLord.

Our casual games also delivered a good quarter with 3.9% sequential growth, while solid growth in most of our casual game titles were partially offset by the decline in BNB, our oldest casual games offering. We are confident that our growing portfolio of new casual games will deliver consistent revenue streams over time. Jun Tang will discuss our online games business in more detail.

Now turning the discussion to our home strategy. I would like to emphasis again that our strategic position is to become an internet-based content aggregator and provider, offering our users a diversified interactive entertainment content portfolio based on our unified operation platform.

In the first quarter, we will continue to make good progress in building business partnerships and developing the distribution models for our EZ Pod product. Following the signing of an order to purchase agreement with five leading PC manufacturers in China, including [Guangzhou], HEDY, [Hysons] TCL and Tsinghua Tongfang. Most recently in April we announced a strategic partnership with China HP whereby HP will bundle our EZ Pod with their digital home product.

EZ Pod sales were relatively slow in Q1 as we focused on building important partnerships and a push for sell through. So far, the number of users that have registered on our EZ Pod platform reached approximately 51,000 out of the total 125,000 sets of EZ Pod that we have sold by the end of the first quarter.

Based on the initial feedback we collected from early adopters of our EZ Pod, online video games appear to be the most popular application among all of the interactive entertainment offerings. This is exactly where Shanda's core competence lies, and also where the industry is heading too.

The next generation game console, like xBox 360 and PlayStation 3 are increasingly focusing on the online and the interactive aspects of video games. We are optimistic that online video games is in ideal intersections of our home strategy and core business. It will be a key application on the EZ Center platform and should be the primary focus of our home strategy at the a current stage.

In addition to the recently launched titles such as Crazy Cards and Shanda Rich Man we have more than six online video games in various development stages, and are scheduled to debut throughout the remainder of 2006.

In summary, we saw encouraging early results from our operation as a Company that has undergone a transition period. We are on the right track to carry out our home strategy, step by step. We are determined to make Shanda's content more easily accessible and enjoyable for end users. First by enabling consumers to change the way they navigate the Internet and entertainment content on their PCs from sitting up close and leaning forward by using a mouse, to relaxing and leaning back in comfort using a remote control.

Before I turn the call over to Jun, I would like to comment on Shujun's decision to step down as CFO of Shanda. Shujun has been a valued member of this management team and a big part of our success as a company. He will remain a peer advisor as part of our board of directors, and we wish him well in his new career endeavors.

Taking over for Shujun is Daniel Zhang, Shanda's current financial controller. Daniel has been with Shanda since last September and has quickly gained in-depth knowledge of our business. I am confident that he is ready to step up as our next CFO. Daniel brings to Shanda strong experience in reporting, finance and accounting and we welcome him to our executive team.

I would now turn the call over to Jun Tang for further discussion on our operations.

Jun Tang

Thank you, Tianqiao. Our online game business has stabilized in the first quarter, as our in-game, item-based revenue model for MMORPGs began to take shape. Our casual games have posted healthy quarter-over-quarter growth. Total game revenues in the first quarter was $38.6 million, down 0.7% quarter over quarter.

Total average concurrent users increased 5% quarter-over-quarter to approximately 1.35 million. Total peak concurrent users in Q1 decreased 80% quarter-over-quarter to 2.45 million. On the MMORPG side, revenues in the first quarter decreased to 2.4% quarter over quarter to $28.1 million. Total peak concurrent users for MMORPGs decreased 12% quarter over quarter to $896,000 while a total average concurrent user increase 28.7% quarter over quarter to 706,000.

Monetization of the new in-game, item-based revenue model is trending well. In Q1, we recorded a 2.47 million active game accounts, which on average spend RMB30.4 per month. Going forward, we will continue to disclose this figure as the MMORPG of revenue is no longer driven by the amount of playing time.

Turning to the casual games, revenues for the first quarter increased revenue from Bianfeng, Haofang and GameABC grew 2.9% quarter over quarter to $10.5 million. This sequential growth was mostly attributable to a seasonally stronger first quarter, as the winter vacation and Chinese New Year holiday provided more free time for game playing.

Worth mentioning is the strong usage we experienced in Maplestory at GetAmped during the Q1. In particular, Maplestory has surpassed the BNB as our leading casual game revenue contributor. Despite a strong seasonality, BNB continued to decline in both user numbers and revenues, as it is approaching the end of its third year in operation.

Peak concurrent users for all casual games decreased 6.2% quarter over quarter to 1.56 million; where average concurrent users decreased 13.1% to 648,000 in the first quarter. Active paying accounts for the casual games have declined 7.2% quarter over quarter to 2.05 million. Average monthly revenue per paying account increased 13.9% quarter over quarter to RMB11.6.

Going forward, we remain confident in our pipeline of upcoming games on the MMORPG side. ArchLord has been in closed beta testing since late April, and will commence open beta testing in June. D&D will begin open beta testing in the third quarter. We expect ArchLord to adopt an in-game item-based revenue model, and D&D to adopt the conventional subscription model.

Also for the casual games, following the successful commercial launch of our in-house development car racing game, Crazy Cars, in March 2006 we plan to commercialize two new casual games; including one South Korean music game, [BJMax] and one in-house developed for casual games during the second quarter.

We are also excited to see that in the first quarter, that [Tellarence] and [Freaky], two item-based role playing games developed by Axis have been licensed by two Japanese companies for operations in the Japan market.

Overall, we are pleased with the performance of our online games portfolio in the first quarter, and we believe our strong pipeline of the games in 2006 will continue to attract the users in China and to further diversify our online games revenue. With that, I will turn the call over to Shujun.

Shujun Li

Thank you, Jun and welcome, everyone. First quarter total net revenue was $42.6 million, representing 31.3% decrease year-over-year and 5.3% decrease quarter-over-quarter. In Q1 2006 revenue contributed by EZ Pod was $1.1 million, which was generated by the sales of approximately 41,000 of EZ Pods, compared to revenue of $2.8 million generated by the sales of approximately 83,700 of EZ Pod in Q4 2005.

Gross margin was 56.8% of net revenues this quarter, down from 71% in Q1 2005; and from 59.9% in Q4 2005. Total operating expenses of $21.9 million declined sequentially, primarily due to lower sales and marketing and general and administrative expenses.

R&D expenses increased 3.2% sequentially, mainly due to increased R&D expenses related to the EZ initiatives. Marketing expenses decreased 30% quarter over quarter. The reduction is primarily attributable to our improved budget control procedures. Going forward, we will focus on the effective usage of our sales and marketing budget, which emphasizes promoting new game launches and our EZ initiative.

General and administrative expenses decreased 42.1% quarter over quarter. The Q4 expenses was impaired due to the recognition of a $[5.1] million provision for doubtful debt, which was significantly reduced in Q1 as a result of our [collection] efforts.

Share-based compensation expenses was $1.5 million in Q1 with the adoption of FAS 123-R we expect our share-based compensation expenses for awards granted to the employees compared to the first quarter of 2006 to be approximately $0.9 million per quarter for the remainder of 2006. This does not include expenses to be recognized during 2006 related to additional employee share awards that are granted in the first quarter of 2006, or non-employee share awards that have been, or may be, granted.

Other income decreased from $5.4 million in Q4 2005 to $1.3 million in Q1. This primarily consisted of foreign exchange gains. The sequential decline was mainly because we did not receive government financial incentives in Q1, which amounted to approximately $5.1 million in Q4 2005. Our receipt of this government financial incentive is subject to time lags and inconsistent practices relating to [inaudible] times.

Net income in Q1 was $1.4 million, compared to the net income of $26.6 million in Q1 2005 and net losses of $66.8 million in Q4 2005. Diluted earnings per ADS were $0.02 for Q1 of 2006, compared to diluted earnings per ADS of $0.36 in Q1 2005 and net loss per ADS of $0.94 in Q4 2005.

The average ADS outstanding for Q1 was 72.1 million compared to 73.4 million a year earlier and 71.2 million in the previous quarter.

Deferred revenue increased 19.5% quarter over quarter to $25.7 million in Q1, mainly due to the implementation of a new policy due to distributor discount rates of our prepaid card. Since the policy was announced in late March, but didn't go into effect until April, some distributors [inaudible] a small prepaid card to enjoy the more favorable discounted rates in March, resulting in an increase in deferred revenue.

That concludes my formal comments. Since this is my last earnings call with Shanda, I want to thank all of you for your support. It has been a pleasure working with all of you, and I look forward to continuing to support Shanda as a director. Thank you, everyone, for joining us today. I would now like to turn the call back to Donglei.

Donglei Zhou

We will now take any questions that you might have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is coming from Safa Rashtchy - Piper Jaffray.

Safa Rashtchy - Piper Jaffray

Good morning, everyone. Thank you. I have two questions; one on the games that you will be developing for the EZ platform. You mentioned in your earlier comments that the early results suggest that the online games are the most popular activities. Can you give us some idea of the schedule for those games? The revenue we can expect from the games and whether these would be the kind of games that you expect only to be primarily monetized through the EZ platform? Or, could they be equally monetized through regular channels? Then I have a quick follow-up.

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

First of all, I would like to clarify the difference between a video game and a conventional PC game. What we mean by video game is typically that the games are played while leaning back, using a game console in more of a relaxed and comfortable fashion. For example, with Playstation 3 and xBox 360.

On that end, we've already rolled out Crazy Cars and Shanda Rich Man and we plan to roll out another six to seven games throughout the remainder of this year. Because those games are all developed based on the PC platform, so the games can be simultaneously enjoyed on the conventional PC platform as well.

However, of course, the experience using a special game console that we were pushing out with EZ Pod together would be much better for the users.

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

Just based on the Crazy Cards and Shanda Rich Man game, we have seen welcoming results from the end users. Based on the logging from both the PC platform as well as the EZ platform. On a daily basis, we get close to 1 million users sign up and play the game.

We expect the experience that we are enabling PC users to enjoy video games in a relaxed, comfortable leaning back type of fashion will be the next trend.

Safa Rashtchy - Piper Jaffray

Thank you. Related to the EZ platform again, can you give us an update on where you stand with regard to the notice that SARFT apparently had issues suggesting that Shanda may be required to have an IPTV license. Could you give us an update on where you stand on that situation?

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

The SARFT comment really comes from an internal circulation or discussion which used Shanda box as an example. I am not sure if you remember or not, but in the third quarter last year we have clearly stated that Shanda will not make any of the boxes ourselves. We will only concentrate our core competence, which is content aggregator and content operator.

Also, in July last year at the SINO CES we have also announced to the industry that Shanda will not produce any of the boxes ourselves. We will provide box solutions to other hardware manufacturers.

So the SARFT comment will not directly affect Shanda's strategic positioning, as well as the roll out.

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

The concept that Shanda has been promoting, which is using a remote control to get our Internet and to enjoy Internet entertainment content is generally okay under the current policy, which is quite clear that content to be distributed over the Internet is regulated by MII and Shanda is okay doing that operation.

We also continue to make good progress and good results in the product rollout and signing up partners.

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

We also welcome direct inquiries or this kind of direct communication from the analysts to Shanda. There are a lot of news and rumors about Shanda out there because we have been in this industry for quite a long time, and a lot of people care about Shanda. We wish this kind of direct communication could help all of you to understand Shanda's strategy and business better.

Safa Rashtchy - Piper Jaffray

Thank you for the explanation and clarification. One last question, if I may. Could you give us your expectations for ArchLord, given that it will be an item-based game; free to play, that is. You have some experience and some feedback and results from your new model. Has that changed your outlook for ArchLord? How should we be looking at that?

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

First I would like to comment that within one quarter, after such a significant change in our business model, we were able to recover our MMORPG revenue to close to 100% of last quarter's level, where last quarter about two-thirds of the time we were still using the old subscription-based revenue model. So I am very happy to see that we have completed this transition, and I am very proud of our game operational team to have produced such wonderful results.

This also increased our confidence in the free to play and item-based revenue model itself.

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

Also the emerging trend in Korea, which is a more mature online game market, is that 21 out of the 30 top ranked games MMOs, they are actually using the free to play and item-based revenue model. ArchLord is one of them. We are very confident that based on the ArchLord game characteristics itself, and also with Shanda's experience and capability in this area, that we should have a very successful operation for ArchLord in China.

Safa Rashtchy - Piper Jaffray

Thank you.

Operator

Our next question comes from James Mitchell - Goldman Sachs.

James Mitchell - Goldman Sachs

Hi, good morning everyone and good luck with everything in the future, Shujun. I had a couple of questions. The first one is, your MMO average users increased about 25% quarter on quarter, which was very impressive. Was that mostly due to new accounts being opened? Or mostly due to existing accounts spending more hours per month online?

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

I think it is really a result of both. I think that Shanda made such a big change, had a very deep impact in the industry. A lot of the old and loyal MIR 2 or War of Legend users that actually have come back and wanted to really use those games as a home base and build their community here again.

Of course, there are also new users being attracted to this platform. As you all know that MMORPG users typically already spend a lot of time playing the game itself, so I think the effect of existing users spending more time, there is some effect but there is definitely also the effect of new users coming into the game.

James Mitchell - Goldman Sachs

Great. And then my second question was, if you look at growing the virtual item business going forward, what is the main lever that you will be pulling? Is it that you are going to be increasing the total number of users for these games? Or is it that you will be increasing the percentage of active users who pay for virtual items? Or do you think you can boost ARPU from here?

When I look at the ARPU of RMB30, that already looks quite substantial relative to what you would get from people paying on a subscription basis.

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

This is a very good question, and it really addresses the fundamental difference between the new model and our old model.

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

Under the old model, ARPU is relatively fixed because the monthly or hourly contribution is essentially fixed by our pricing strategy. So the growth really has to come from the user number growth.

However, under the new revenue model the growth can come from both increase in terms of user base, because of the free model, and at the same time we can increase the percentage of paying users by doing various promotions and marketing of the games.

Third, by continuing to add different value-added services within the game, we can attract the paying users to even spend more within the game.

So from all of these three dimensions, there is room for growth.

Tianqiao Chen

[Response in Mandarin]

Donglei Zhou

So from January to March, during this one quarter, we were able to quickly recover the revenue to almost 100% of our last quarter. Really proved that we have done quite well on all of the three dimensions, and that there is a huge potential for this revenue model.

Of course, by providing the game for free, naturally we can actually attract a lot of users. Also, different users have really different tastes and they would want different items. So then we can give them either functional items or decorative items or whatever they would like.

Once they have identified an area of items or value-added services that the users prefer, we can keep on giving them more and more. So the trend is very favorable in that we believe this model actually suits our user demand much better. That is why we believe it is a sustainable model.

James Mitchell - Goldman Sachs

Great. One final question for me. What was the change in commission structure for the prepaid card distributors in April?

Tianqiao Chen

I will ask my financial controller, Daniel Zhang, to answer your questions.

Daniel Zhang

In March, we announced that we will adopt a new discount policy beginning on April 6th. Under the new policy, for e-sales cards, the current rate changed from 23% to 15%. For offline cards, the rate changed from 14% to 12%. Since [inaudible] has not changed the discount rate for over three years, and we believe the new rate is in line with the overall market.

James Mitchell - Goldman Sachs

Great. And the prepaid card distributors have accepted these changes?

Daniel Zhang

Sure. And on the other hand, we also changed our payment model and we will give our distributor more prepaid and incentives based on how much they sell and what kind of game cards they sell.

We will give them more incentives for some of our new games during a certain period Based on our new policy, we will be able to encourage our distributor to promote the games and have more control over the distributors.

James Mitchell - Goldman Sachs

Thank you very much. I've taken up a lot of time. Thank you.

Operator

Your next question is coming from Wallace Cheung with CSFB. Please go ahead.

Wallace Cheung - CSFB

Hello, thank you for picking up my question. I actually have two key financial questions on the balance sheet side. Firstly, can you explain why some of the cash items, like the restricted cash, cash equivalents and short-term investments, I am seeing some decline on a quarter on quarter basis. Secondly, why the goodwill item has jumped, it seems quite substantially, from RMB245 million to RMB494 million? Thank you very much.

Donglei Zhou

[Translation in Mandarin]

Shujun Li

The decrease in cash and cash equivalents is mainly due to the fact that we paid $31 million and the last installment for reporting Haofang, and alternatively, the consideration we paid is partially from the goodwill, which represents the increase of the goodwill in the balance sheet. Thank you.

Wallace Cheung - CSFB

So can you explain, what is the total consideration of Haofang consideration?

Shujun Li

The total consideration we pay for acquiring Haofang is $56 million.

Wallace Cheung - CSFB

Thank you very much.

Operator

Thank you. Your next question comes from Antonio Tambunan with Bear Stearns. Please go ahead.

Antonio Tambunan - Bear Stearns

I have a quick question, I just wanted to follow up on the outlook for ArchLord versus D&D. It almost sounds like in light of your success with the free-to-play model, that ArchLord might actually be a little bit more successful than D&D Online. Would that be a fair assessment? Your expectation for ArchLord compared to D&D Online, I guess is what I am asking.

Donglei Zhou

[Translation to Mandarin]

Tianqiao Chen

[Response in Mandarin]

Translation

I think two business models has both pros and cons. I think it depends on the life cycle of the game, and also the type of game. For example, the game style Shanda has already allowed a free-to-play model are typically mid to long, in terms of life cycle, and already approaching sort of the later stage of their life cycle, where we have attracted a lot of loyal users, but we wanted to expand that user base to attract even more people, and to create a balanced economic system within the game.

Whereas the D&D, in terms of the game type itself, it is rather an online combat or fighting or quest type of game, so the rules within the games are quite strict, which does not really play well with the item-based model.

The ArchLord in Korea is already a free-to-play model, so from the game design itself, it is suitable for the item-based revenue model, whereas D&D, the game itself is from the North America market, and it plays much better with the conventional subscription-based model.

So we are quite confident that the two models we are using for two games are both going to do well.

Antonio Tambunan - Bear Stearns

Okay. The other question I have is you were talking about the decorative versus functional items that you guys sold. Was it decorative or functional items that drove the revenues for the MMORPG?

Donglei Zhou

[Translation to Mandarin]

Tianqiao Chen

[Response in Mandarin]

Translation

That also really depends on the game, and also the user base. For example, for Magical Land and also Maplestory, the users are typically younger and more female, so they do not mind spending RMB50 buying a virtual birthday cake to dedicate to their friend. It is not very much decorative or functional, but it is something that they are actually willing to pay because it provides value to them.

So it is really an art to master the technique we need to use to introduce the items that are both going to be liked by the users but also does not destroy the balance of the game playing itself. We are quite confident that we are getting good at that.

Antonio Tambunan - Bear Stearns

Thank you.

Operator

Thank you. Your next question is coming from Dick Wei with JP Morgan. Please go ahead.

Dick Wei - JP Morgan

Good morning. I have a question on Shanda’s home strategy. It has been my observation that Shanda seems to be spreading its focus in terms of the EZ Center platform to EZ Pod from EZ Station. Particularly, it seems that the EZ Station launch date is quite controlled by your manufacturing partner.

If that is the case, is it that Shanda is more focusing on the study room, the EZ Pod, rather than going to the living room by using EZ Station? If that is the case, does that mean the whole EZ Pod market is quite a lot smaller because the PC users are less than the TV users in China? Thank you.

Tianqiao Chen

[Response in Mandarin]

Translation

First of all, your assumptions that we were doing [inaudible] before, I would just like to remind you all to pay more close attention to our official comments or announcements. For example, last July, when we displayed the box, it was the first time we displayed.

Yes, the first time we displayed the box in the SINO CES, we said that we would not do the box. It is really for the hardware manufacturers, and we will focus on providing solutions and operating the content platform going forward.

Also, in the third quarter, we have also announced that to the investors community, so I would not really explain any comments on that, whether we are shifting or moving our focus.

[Response in Mandarin]

Translation

The solution we provide really allows users to change the way they consume Internet entertainment content from leaning forward to leaning back in comfort. Based on that direction, we are a content and service provider. So that makes Shanda an ideal partner for both the IP license owners to provide content and service for them, for example, and also a partner for EPC solution provides, for example, Intel and Microsoft. Whether it is IPTV or EPC solutions, they all need abundant content, and that is what Shanda has.

So we are just one part of [inaudible], and we continue to move toward a direction of entering into homes and providing a better entertainment experience from a leaning forward fashion to a leaning back in comfort fashion.

Dick Wei - JP Morgan

Maybe my question was not too clear. While I understand that the Shanda model is more in the distribution and content subscription revenue model, I wonder, just of the TV, the available market who can subscribe to the Shanda content, the number of PC’s, there may be only 70 million home PC users in China versus thereabout 400 million TV users, or TV households in China. That is quite a different market size available for you to distribute and sell your content.

I wonder if maybe in the next 12 to 18 months, you will be more focused on the existing PC user rather than focusing on the living room TV user at this point? Then longer term, you will be focusing on distributing your content to the TV user.

Donglei Zhou

[Translation in Mandarin]

Tianqiao Chen

[Response in Mandarin]

Translation

This really is a complex industry question. I will try to explain it. First of all, using PC’s to enter living room is really an industry trend that we are seeing. We see that the PC monitor that we use as a display is getting bigger and bigger. The EPC solution that you can both watch TV and access Internet from the living room is actually advocated by both Lenovo, a hardware manufacturer, as well as AMD, as a chipset provider.

So the home living room, whether you use a TV or use a PC, that is really not a clear line anymore. The convergence trend is already very clear. We are a player in the living room culture. We are one member of the entire team, industry team that is trying to get into the living room and provide the overall better entertainment experience to consumers.

[Response in Mandarin]

Translation

So that is exactly why Intel and HP and other big PC manufacturers are partnering with Shanda on the EZ level, instead of just working with us on a particular game. So our position as a solution provider and a platform provider is already recognized by the entire industry.

I think our direction has not changed. However, our position is more clear than ever.

Dick Wei - JP Morgan

Thanks a lot for the explanation, Mr. Chen.

Tianqiao Chen

[Response in Mandarin]

Translation

I think we have just time to take one more question, if there are any.

Operator

Thank you. Your last question is coming from Chang Qiu with Forun Technologies. Please go ahead.

Chang Qiu - Forun Technologies

Good morning. Maybe one question. You actually [parted] that a little bit earlier. There is some concern regarding the stability and also sustainable growth for your virtual item sales business model. Going forward, maybe you can give us some idea how you make the growth more sustainable?

Donglei Zhou

[Translation to Mandarin]

Tianqiao Chen

[Response in Mandarin]

Translation

This is a good question, and I will try to answer from two angles.

[Response in Mandarin]

Translation

First of all, from an individual end-user’s perspective, the purchase may be spontaneous or impulse-based. However, if you have hundreds of thousands, or millions of users all buying the items, then it is not impulse buying. It is a sustainable model.

Secondly, if you look at, for example, a shopping mall. Within a shopping mall, each particular boutique store sales may be up and down from time to time. However, the shopping mall itself, given that it is diversified and it has all kinds of products, in itself, the growth or the revenue is sustainable.

So in terms of scale, Shanda has already reached that kind of scale, in the sense that we are almost a shopping mall.

[Response in Mandarin]

Translation

So first, now that we have scale, however, Shanda is not a simple e-commerce online store, or online shopping mall. We are really based on a community, so the community itself continues to attract more and more users, and the culture, the content itself continues to create demand from the end-users, and we as a company can fulfill that demand.

So it is almost like Disney. The Disney culture and the Disney stories keep on creating dreams for kids, and creating that demand that they want a Minnie Mouse or a Donald Duck, so their product can then sell very well among all the users. That is why Disney is such a successful theme park.

So Shanda’s content attracts users, and then in return, we can give them e-commerce product or other services that will fulfill that demand. So this is really the core of interactive marketing.

Chang Qiu - Forun Technologies

Thank you. I have some more questions, if I may. For Q1, for your MMORPG, you said all of the games are by virtual item sales, or you still have some games by subscription?

Tianqiao Chen

[Response in Mandarin]

Translation

Currently, the majority of our MMORPG revenue is actually from games that are using the item based model. Going forward, like I said earlier, it depends on the game type and life cycle. We will adopt different models appropriate for that particular game.

Chang Qiu - Forun Technologies

Okay. For the EZ part of sales, in Q1, what is your gross margin?

Donglei Zhou

[Translation to Mandarin]

Tianqiao Chen

[Response in Mandarin]

Translation

We are not going to disclose the detailed breakout of margins.

[Response in Mandarin]

Translation

Because we just launched the product last December, it is still in the very early stages for this market rollout. The numbers are not ready to be disclosed, and they are not going to be very meaningful.

Chang Qiu - Forun Technologies

Okay, maybe a question for Daniel, or maybe Shujun too. For Q2, what should we expect on the operating expense side, maybe relative to Q1?

Shujun Li

I expect the operating expenses in Q2 will be more stable under our improved budget controls, so I think the trend will be better.

Chang Qiu - Forun Technologies

Thank you.

Operator

Thank you. That concludes the call for today.

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