NetEase Q3 2009 Earnings Call Transcript

Nov.18.09 | About: NetEase, Inc (NTES)

NetEase.com, Inc. (NASDAQ:NTES)

Q3 2009 Earnings Call Transcript

November 18, 2009 8:00 pm ET

Executives

Brandi Piacente – Investor Relations

Onward Choi – Acting Chief Financial Officer

William Ding – Chief Executive Officer

Analysts

Richard Ji – Morgan Stanley

Wallace Cheung – Credit Suisse

Dick Wei – JPMorgan

Alicia Yap – Citigroup

Ming Zhao – SIG

Gary Ngan - UBS

Kathy Chen – Goldman Sachs

Eddie Leung – Bank of America/Merrill Lynch

Operator

Ladies and gentlemen, welcome to the NetEase third quarter fiscal 2009 earnings conference call. (Operator instructions)

I would now like to turn the conference over to Brandi Piacente, Investor Relations for NetEase. Please go ahead, Madam.

Brandi Piacente

Thanks, operator. 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. A general discussion of the risk factors that could affect NetEase's business and financial results are included in certain filings of the company with the Securities and Exchange Commission, including its annual report on Form 20-F. The company does not undertake any obligation to update this forward-looking information except as required by law.

As a reminder, this conference is being recorded. In addition, a webcast replay 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 Onward Choi, Acting Chief Financial Officer, who will read the prepared remarks on behalf of Mr. William Ding, Chief Executive Officer of NetEase.

Onward Choi

Thank you, Brandi. Total revenues for the third quarter of 2009 increased to $128.8 million, compared to $127.8 million in the prior quarter and $118.2 million in the third quarter of 2008.

Revenues for our online games business totalled $113.6 million for the third quarter of 2009, compared to $114.5 million in the second quarter and $98.9 for the third quarter of 2008.

An outstanding performance highlight for the quarter was Fantasy Westward Journey's record peak concurrent users of 2.5 million on August the 2nd, up from peak concurrent users of 1.7 million in the second quarter and compared to our previous PCU record of 2.3 million achieved in August of last year.

Daily ACUs were 575,000, compared with the same number in the second quarter and new registered users increased 5% quarter over quarter. Fantasy Westward Journey's recent performance is a clear testament to the ongoing popularity and longevity of this iconic game.

We believe that the longstanding success of Fantasy Westward Journey and our other leading self-developed games is due to our strong and talented research and development team who continually provide superior gaming experiences to the growing dynamic user community in China. We increased the size of our R&D team by approximately 10% during the third quarter to 1,100 game developers.

PCUs and ACUs for Westward Journey II were 547,000 and 199,000 in the third quarter respectively, compared with 591,000 and 207,000 in the second quarter respectively. The newest expansion pack for this game, [inaudible], was released in August.

On September the 19th, 2009, our [inaudible], Shanghai EaseNet, commenced the commercial operations in China of World of Warcraft, a game licensed from Blizzard Entertainment, after receiving the necessary approvals from appropriate government authorities. We are pleased to report that the World of Warcraft player response has been huge.

As we have previously disclosed, there is some regulatory uncertainty regarding World of Warcraft following an announcement by the PRC general administrator of press and publications. We are currently seeking clarifications from the relevant governmental authorities regarding the statement by JPP and look forward to a speedy resolution from the Government authorities.

We have submitted the applications for Wrath of the Liche King to the relevant government authorities for review and approval and we hope to be in a better position to discuss timing for Wrath of the Liche King in due course.

In September, we conducted a month long marketing and sales campaign for the much anticipated open beta launch of Tianxia 2. The open beta results match our targets in terms of both the number of players and paid users, and we are optimistic about the future growth of this game.

For the current quarter, we will release four expansion packs for Legends of Westward Journey, Tianxia 2, New Fly for Fun, and TF Online. In our new game pipeline, we started closed beta testing of Ghost on August the 7th and continue to make design improvements based on player feedback. We expect to commercialize this item-based game in mid 2010.

This is another much anticipated 3D online game which based on Liao-chai chih-I, the famous collection of classic Chinese ghost stories, with the beautiful music and beautiful scene settings as well as rigorous fighting modes in the game, players can experience life and death, laugh and anger, as well as revenge and other emotions in the human world, heaven, and hell.

We also started limited closed beta testing of Legend of [Gai Tun] in the third quarter of 2009. At present, we are making improvement to the game design. We expect to commercialize this game in mid 2010 as well.

We have two self-developed item based web games planned for launch before year-end. These titles are [Well of Sangwar], which was commercialized in early August of this year, and Storm of Empires, which is expected to be commercialized in the fourth quarter of 2009.

We are excited about each of the new games in our development pipeline, which we believe will further diversify our user base and enhance the popularity of our game portfolio.

Now turning to the advertising business, revenues from advertising services were $12.6 million for the third quarter of 2009, compared to $10.7 million and $16.6 million for the preceding quarter and the third quarter of 2008 respectively.

Our recent consolidation of NetEase portal operations in Beijing as well as other new marketing strategies launched in the beginning of the year began to deliver promising results. We believe the consolidations of our sales, content, and portal business related marketing functions are best managed and streamlined in our Beijing office.

The primary objective is to facilitate closer communications and coordinations between these functions and bring about improved content and marketing support with the overall goal of attracting new advertisers and keep longstanding relationships with existing ones.

Following the consolidations, we have strengthened our market competitiveness, resulting in a steady growth in both the number of advertisers and sales revenues. In terms of total revenues, the top three performing vertical sellers for the third quarter was automobiles, Internet services, and communication services.

Although short-term macroeconomic data is uncertain, we have undoubtedly achieved an upward trend in our advertising business and we remain cautiously optimistic about the cost of improving advertising sales through the remainder of 2009 and into 2010.

That concludes William's remarks on games, advertising, and portal. Now I will provide a review of our third quarter 2009 financial results using numbers and percentages based on U.S. dollars. In order to avoid repetition with the press release, I will primarily focus on the discussion of margins and expense fluctuations along with net profit.

Gross profit for the third quarter of 2009 was $91.9 million, compared to $101.4 million and $92.5 million for the second quarter of 2009 and the third quarter of 2008 respectively. The quarter over quarter decrease in gross profit was primarily attributable to the additional cost of revenues incurred for the ramp-up and operations of the licensed game World of Warcraft, mainly comprised of server depreciation charges, [inaudible] and royalties, which was partially offset by increased advertising revenues in the third quarter of 2009.

The year-over-year decrease in gross profit was primarily attributable to the significant increase in cost of revenues incurred for the ramp-up and operations of World of Warcraft and decreased advertising revenue, partially offset by increased game revenue in the third quarter of 2009.

Lower advertising revenue was recorded for the third quarter of 2009 as the 2008 Olympic event ceased. High game revenue was reported for the third quarter of 2009 mainly due to the continued popularity of our self-developed games during the summer holidays, as well as the commercializations of World of Warcraft on September the 19th.

Gross profit margins for the online game business for the third quarter of 2009 was 79.9% compared to 88.3% and 89.7% for the preceding quarter and the third quarter of 2008 respectively. The quarter over quarter and year-over-year decreases in gross profit margins were primarily attributable to the additional cost of revenues incurred for the ramp-up and operations of World of Warcraft in the third quarter of 2009.

Gross profit margins for the advertising business for the third quarter of 2009 was 23.1% compared to gross profit margins of 16.6% and 26.9% for the preceding quarter and the third quarter of 2008 respectively.

The quarter over quarter increase in gross profit margins was mainly attributable to the sequential increase in revenue during the third quarter of 2009. The year over year decrease in gross profit margins was mainly attributable to the decrease in revenue in the third quarter of 2009 as the 2008 Olympic event ceased.

Gross loss margins for the wireless value-added services and others business for the third quarter of 2009 was 45% compared to 43% for the preceding quarter and 6.4% for the third quarter of 2008. The quarter over quarter and year over year increases in gross loss margins were mainly due to increased bandwidth and server custody fees resulting from increased traffic for email and photo blog services, as well as increased staff related costs resulting from increased headcount in the third quarter of 2009.

Total operating expenses for the third quarter of 2009 were $32.1 million, compared to $25.6 million and $24.1 million for the preceding quarter and the third quarter of 2008 respectively. The quarter over quarter and year over year increases in operating expenses were mainly due to the nationwide promotional activities conducted for many of our self-developed games during the summer holiday seasons and the relaunch of World of Warcraft in September 2009, along with increased advertising media and [exhibition] costs to promote the portal business during the third quarter of 2009.

We also recorded quarter over quarter and year-over-year increases in research and development costs during the third quarter mainly resulting from increased headcount and increased server custody fees and bandwidth charges related to our research and development activities.

Net profit for the third quarter of 2009 was $57.7 million, compared to $68.6 million and $45.9 million for the preceding quarter and the third quarter of 2008 respectively.

During the third quarter, we reported a net [inaudible] gain of $3.7 million under [other net] compared to $6.9 million for the preceding quarter and a net foreign exchange loss of $10 million for the third quarter of 2008. The quarter-over-quarter and year-over-year changes in foreign exchange gains and losses were mainly due to the translation gains and losses arising from the company’s Euro-denominated bank deposit balances as of September 30, 2009 as the exchange rate of the Euro against the RMB fluctuated over the periods.

We reported basic and diluted earnings per ADS of $0.45 and $0.44 respectively for the third quarter of 2009. This compares to basic and diluted earnings per ADS $0.53 each for the preceding quarter and $0.36 and $0.35 respectively for the third quarter of 2008.

We recorded an income tax charge of $9.6 million, $16.9 million and $18.4 million for the third quarter, the preceding quarter and the third quarter of 2008 respectively. The effective tax rate for the third quarter of 2009 was 14.3% as compared to 19.8% and 28.6% for the preceding quarter and the third quarter of 2008 respectively. The quarter-over-quarter decrease in tax charge was primarily due to the payment of an extra tax charge of $5.6 million recorded in June 2009 related to the tax assessment of 2008 and the first quarter of 2009 by one of our subsidiaries. The year-over-year decrease in tax charge was primarily due to the application of the statutory tax rate of 25% on the income of the subsidiaries in the third quarter of 2008 as approval for the preferred tax status of High and New Technology Enterprises was not received until December 2008.

Cash flows generated from operating activities totalled $39.5 million for the third quarter of 2009, compared to $79.7 million and $72.6 million for the preceding quarter and the third quarter of 2008 respectively.

In addition, the company has a restricted cash balance of $12 million. We maintain a very strong balance sheet with ample cash resources to fund our ongoing developments of world class online games and premium online content and our third party licensing arrangements.

As of September 30, 2009, the Company’s cash and time deposits totalled $939.1 million, compared to $822.3 million as of December 31, 2008.

On September 12, 2008, the Company’s Board authorized a share repurchase program of up to $100 million of the Company's outstanding ADSs for a period not to exceed one year. As of September 11, 2009 when the share repurchase program ended, we had spent in aggregate a total purchase consideration of approximately $13.1 million including transaction costs.

Thank you for your attention. We will now be happy to take your questions. Operator, please go ahead.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Richard Ji.

Richard Ji – Morgan Stanley

I have two questions -- first, let me start with World of Warcraft and this is obviously the key focus for [inaudible] and can you share with us an incremental development on the regulatory front and given this is a big overhang.

And the second -- secondly, can you also give us some color on the performance metrics and for World of Warcraft after commercialization.

William Ding (Translation)

To answer your questions on World of Warcraft regarding the regulatory development, from the company's point of view, we will always follow the prevailing rules and regulations in doing the relevant and appropriate applications and approvals and to make sure that we would be in compliance in making sure that our operations or the launch of the product or the game itself should be fine.

And regarding the performance metrics by now, since the launch of the games, from the company's perspective we are quite satisfied with the -- with its performance so far.

Richard Ji – Morgan Stanley

Thank you and let me ask another question and clearly you have a very deep self-developed pipeline and especially Tianxia 2 has recently turned into a blockbuster. And can you share with us some of the so-called performance metrics, as well as the outlook and your expectation for Tianxia 2 going forward? And also among your new games, which ones would you expect they may have a chance to turn into a new blockbuster? Thank you.

William Ding (Translation)

Regarding your first questions about the performance of Tianxia 2, so far the company's view is that our -- the market performance is quite -- we are quite satisfied with its market performance and with regarding the company's strategies or the wishes going forward to further develop this game, we will continue to add in more new content and more new game plays to attract players. And also both the management and also the game developers also set very high expectations in making sure that through the various efforts in bringing up the operations of this game, we aim to make this game to be one of the most popular 3D MMORPG games in the China market.

And regarding our new game pipeline development, I think towards the end of 2009 and up to -- or early 2010, what we are currently doing, we will still continue to proceed on and say, for example, the [inaudible], one of our new games are still under the testing phase and we will still proceed to move on and making sure that it will be another new and popular games to the market.

Richard Ji – Morgan Stanley

Thank you.

Operator

Your next question comes from the line of Wallace Cheung.

Wallace Cheung – Credit Suisse

Just quickly on the cost side, can you give us a bit more color in terms of the cost of goods sold as well as the operating expenses, how much has been contributed from the World of Warcraft? Thank you.

Onward Choi

I think for the third quarter, basically we have launched the game since the 19th of September and we are already taking in the revenues of this game and for the cost of this game, I think by now it would include both the IDC cost, the server depreciation charges, and the royalties and such that we have already stated and discussed in the release. And I think this would also be the profile that we would be continuing to move on going forward.

Wallace Cheung – Credit Suisse

And another question is regarding the wireless and other subscription business. We are seeing both the revenue lines and cost of goods sold line actually increase and also [inaudible] the server cost for the [inaudible] [servers to increase], is there any indication that the user level on the [email servers] is increasing and potential monetization of the email is actually improving as well?

Onward Choi

We believe so because we are continuing -- this is a continued effort for us to develop our existing email services and from time to time, we would also try to build up our server facilities to cope with the demands or the usage of our users. And so we are still quite satisfied with its performance by now.

Wallace Cheung – Credit Suisse

How much of the revenue in this line is coming from the email related services?

Onward Choi

In terms of the email services, I think -- just a moment.

(Translation not provided)

Wallace Cheung – Credit Suisse

Okay. Thank you.

Operator

Your next question comes from the line of Dick Wei.

Dick Wei – JPMorgan

My question is, the first one, is for the pipeline in 2010, can you talk about which one or two will be kind of the key gains for the -- or have the highest expectation by the company?

William Ding (Translation)

Basically the company will take a very serious approach in for whatever new game is being developed and for all the new games that are due to go out to the market in the upcoming years, for each of those games we also have high expectations of them and we believe that they would also perform well, because there will be various kinds of games that we put out in the market, including 2D and 3D and different game types, including those like the role playing games and some other casual games and things like that.

Dick Wei – JPMorgan

Great, just two more questions on the financial side. First one is on the cash flow statement, the prepayment and other current assets, about RMB248 million. Is that mainly related to some payment to Blizzard?

Onward Choi

Correct.

Dick Wei – JPMorgan

And then, as far as the deferred revenue is concerned, I think that the Q-over-Q increase, was it mainly due -- I mean, I don’t know if you are able to comment how much has come from typical higher seasonality around October 1st and how much is from the Warcraft? Thanks.

Onward Choi

I think basically the increase in our deferred revenues for the third quarter mainly come from two areas. One of those would be from the launch of the World of Warcraft where the players would also buy more points to play the games and the other parts would definitely come to the fact that in anticipation of the coming national holidays and the [distributors] usually buying more [inaudible] to reach the demands during the national holidays.

Dick Wei – JPMorgan

Okay, great. Thanks a lot.

Operator

Your next question comes from the line of Alicia Yap.

Alicia Yap – Citigroup

Good morning. I have two questions. First of all, can you comment on the competitive dynamic for the 2D turn-based game? As there have been some newly launched 2D games in the market, have you seen any impact, especially to your Fantasy Westward Journey? If so, what will be your strategies to defend your market-leading position?

William Ding (Translation)

Basically from the [macro world], we believe that the whole industry is getting more and more competition and the competition is getting more intense and the expectations from the players are also higher and higher.

But having said that, whether this would -- whether the game itself is 2D or 3D is not that important. What is more important is how well we could really deliver in the games because we always believed that even for the 2D games, we can also do it in a very nice manger by having very good game play and very good content therein in order to attract the players and to making sure that they would continue their interest to play the games. And so this would just be a matter to prove that it would continue to be a success.

Alicia Yap – Citigroup

Thank you. My second question is regarding the advertising business. So have you seen meaningful uptake from the demand environment after the Golden Week holiday? And particularly which sectors have the most potential to experience highest growth in the fourth quarter and into 2010?

Onward Choi

I think basically for the advertising business, we have seen that for 2009, it has been a very challenging year and in the past three quarters, we have seen that the development has been progressing well and especially you will see that in both the second quarters and the third quarters, there has been an increase or a growth in terms of our advertising revenues. And so far from what the company has observed and recorded, we believe that the top three vertical industries would be the automobiles, the Internet services, and also the communication services industries.

Alicia Yap – Citigroup

That was three categories in the third quarter. Would that be similar for the fourth quarter and 2010 in your expectation?

Onward Choi

I think for the quarters going forward, I think at this stage we wouldn’t be able to give you a very concrete answer but basically from what we have seen so far, we still see that those industry verticals will still have a good room to develop.

Alicia Yap – Citigroup

Okay. Thank you so much.

Operator

Your next question comes from the line of Ming Zhao.

Ming Zhao – SIG

Thanks for taking my question. Just two quick number questions -- Onward, can you tell us if you have recognized any deferred revenue from those dormant accounts this quarter?

My second question is if we look at sales and marketing expense, how much of that was due to launching Tianxia 2 and how much of that due to World of Warcraft and how should we look at this line in the fourth quarter? Those are my questions. Thank you.

Onward Choi

Sorry, Ming, for the first question regarding deferred revenue, can you repeat again what exactly that you would like to ask about?

Ming Zhao – SIG

I think last quarter you recognized $12 million of --

Onward Choi

For the dormant accounts -- you mean the dormant accounts?

Ming Zhao – SIG

Yeah, how much did you do this quarter?

Onward Choi

I think the company -- we didn’t disclose this number for this quarter but because for the second quarter, this would be our first-time doing the clean-up for those dormant accounts and in lieu of the fact that the dollar amount is relatively more material and significant and so we will give you a sense but what we can share with you is that for this quarter, the amount of deferred revenues coming from those dormant accounts wouldn’t be that bad.

Ming Zhao – SIG

Okay. And then the second question about the sales and marketing expense -- how much of that is due to World of Warcraft and how much is due to Tianxia 2? And is there going to be a significant reduction in the fourth quarter?

Onward Choi

Maybe I will just answer you from different angles -- for the third quarter, the sales and marketing expenses, the increase would mainly be come into two areas. One would be on our existing self-developed games on our various game titles because starting from the third quarter, we have started to carry out more marketing and promotional activities for various of our game titles. And the other area that we have increased our marketing and selling expenses is that we have also do more brand activities to promote the company's brand names and things like that. And for the third quarter, I think the contribution with regard of the World of Warcraft wouldn’t be that significant, only to the effect that you would realize that we only just launched the games on the 19th of September.

But going forward, we would still believe that the companies would continue to put in more efforts in doing the selling and marketing activities.

Ming Zhao – SIG

All right, great. Thank you.

Operator

Your next question comes from the line of Gary Ngan.

Gary Ngan - UBS

I have a couple of questions. Firstly, on the increase in cost of revenues in Q3, as you mentioned, those -- the increases from depreciation, amortization, and royalty, so I looked at it, depreciation increased by RMB22 million while the cost of revenues increased by RMB63 million, so the difference is -- it's 40 million, so what exactly is in that 40 million and how much of that is start-up costs? Can you give us a [sense of that]?

Onward Choi

I think we wouldn’t give out a further breakdown but basically you are right that the increase in the cost of revenue would be mainly comprised of the server depreciation charges for this quarter and also the custody fees and royalties, and things like that.

Gary Ngan - UBS

Thanks. So my next question is I guess Shanghai EaseNet is an affiliate of the company and I actually don’t really see that line being captured in the financial statement. Can you tell us where exactly it would be?

Onward Choi

I think basically because this is one of our affiliate companies and just as what we have catered for, our other companies in our group, this would be considered on a consolidated basis and so there wouldn’t be any separate lines that we are going to show.

Gary Ngan - UBS

Okay, so would I be correct to assume that actually the 50% joint venture profit that goes to your partner actually will be captured in the minority line?

Onward Choi

I think we wouldn’t make further comments on this kind of question. Sorry for that.

Gary Ngan - UBS

Thanks. My final question is the Ministry of Culture announced a new rule on the games regulation and particularly they said they will have to make a more stringent control on the PK system, [wedding] system, and also the levelling mode of the games, so what do you think the impact would be to our games?

William Ding

(Translation not provided)

Brandi Piacente

Just one second, maybe we can translate that.

Onward Choi

Sure. I think basically the companies would like to reiterate that at all times for an online game company in China, what we have done would be in full compliance with the relevant rules and regulations and this is what we have always been doing and would be doing going forward.

Operator

Your next question comes from the line of Kathy Chen.

Kathy Chen – Goldman Sachs

Thanks for taking my question. I just have one question regarding the Fantasy Westward Journey and Westward Journey II trends during the quarter -- it looks like the Fantasy Westward Journey ACU as flat quarter on quarter and down about 15% year-on-year, while the Westward Journey II ACU is down about 4% quarter on quarter. Can you explain the weakness in the quarterly trend, given I think that third quarter is usually a seasonally stronger quarter for you. Are you seeing these gains reach a more mature stage or is it due to higher competition from some new games during the quarter? Thanks.

Onward Choi

Thank you for your questions, Kathy. I think basically for the third quarter, traditionally this would be our highest season because of the summer holidays. Even though from the ACU numbers that you have just mentioned doing some sort of comparison, but we still see that the overall performance of the games themselves is quite good. And especially through our launch of some promotional activities and the launch of some new expansion packs to the games. And at all times, we don’t believe that the games themselves have come to a point where it was because from time to time, we would always launch out some new expansion packs to enrich the content inside the games and also to enrich the game play and features of the games in order to making sure that the interest of the players can sustain and would sustain, continue to play the games with us.

Kathy Chen – Goldman Sachs

Thanks. If I could just add a follow-up, can you remind us whether there was an expansion pack launch for both games in the third quarter and whether there will be any expansion packs to be launched in the fourth quarter?

Onward Choi

If you are talking about the launch of the expansion packs for the Fantasy Westward Journey, in fact we have already launched another new one on the -- in mid-October, whereas for the Westward Journey II, we have already launched another new expansion pack in mid-August this year.

Kathy Chen – Goldman Sachs

Thank you.

Operator

Your next question comes from the line of Eddie Leung.

Eddie Leung – Bank of America/Merrill Lynch

Just one question -- is there any plans to increase item selling in the two old blockbusters, the [inaudible] and Fantasy Westward Journey? Thank you.

William Ding (Translation)

Right now, we don’t have any plans of doing the item sellings in our existing time-based games, mainly for the Fantasy Westward Journey or the Westward Journey II.

Eddie Leung – Bank of America/Merrill Lynch

Thank you.

Operator

Thank you. Ladies and gentlemen, that does conclude our question-and-answer session for this conference. I would now like to turn the conference back over to management for any closing statements.

Brandi Piacente

Thank you once again for joining us today. Please feel free to contact us if you have further questions. Have a great day.

Operator

Ladies and gentlemen, this concludes the NetEase third quarter 2009 earnings conference call. If you would like to listen to a replay of today's conference, please dial 1-800-406-7325 or 303-590-3030 with the pass code 4175189. Thank you and you may now disconnect.

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