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Changyou.com Limited (NASDAQ:CYOU)

Q4 2013 Results Earnings Call

February 10, 2014, 07:00 AM ET

Executives

Angie Chang - Investor Relations

Alex Ho - Chief Financial Officer

Analysts

Alicia Yap - Barclays

Eddie Leung - Bank of America Merrill Lynch

Evan Zhou - Credit Suisse & Co.

Alex Yao - JPMorgan

Operator

Thank you for standing by, and welcome to the Q4, 2013 Changyou.com Limited Earnings Conference Call. (Operator Instructions). I must advise you that this conference is being recorded today, February 10, 2014. I would now like to hand the conference over to your first speaker today, Ms. Angie Chang, IR Manager. Please go ahead Mr. Chang.

Angie Chang

Thank you, operator. On the call today are Mr. Tao Wang, CEO; Mr. Dewen Chen, President; Mr. Alex Ho, CFO; Mr. Xiaojian Hong, COO; and Ms. Wendy Pan, CIO. I will lead off by providing business highlights on behalf of Mr. Wang and then pass the call to Mr. Ho, our CFO who'll discuss financial results for the quarter just ended. After the prepared remarks he will be joined by the other officers to answer questions.

Before we continue please allow me to read you Changyou's Safe Harbor statement. Statements that are not historical facts, including statements about the company's beliefs and expectations, are forward-looking statements. These statements are based on current plans, estimates and projections and therefore you should not place undue reliance on them. Forward-looking statements involve inherent risks and uncertainties.

We caution you that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statements. For more information about the potential risks and uncertainties please refer to the company's filing with the Securities & Exchange Commission, including its registration statement and most recent annual report on Form 20-F.

Now let me proceed to provide business highlights for the quarter just ended. We are pleased to report that Changyou ended 2013 with solid results in the fourth quarter. Total revenues and revenues across each of our businesses reached new highs in the fourth quarter and were in-line with our guidance.

Total revenues were $194.9 million up 6% quarter-over-quarter and 12% year-over-year. Online game revenue was $172 million, up 6% quarter-over-quarter and 9% year-over-year. Online advertising revenue was $16.9 million, up 3% quarter-over-quarter and 35% year-over-year.

Our performance in the fourth quarter of 2013 reflects the resilience of the user-centric feedback-driven development philosophy that runs through all of our businesses, old and new. Our existing games and online advertising businesses provide the stability in revenues as we think and plan for future in which mobile games and user platforms will be important drivers.

Our massively multiplayer online games or MMO games and web games including flagship titles, like TLBB, Wartune and DDTank are among the most popular games in China. We are also encouraged to see a good number of users taking a license to some of the new Internet products launched in the fourth quarter for our platform initiative. Meanwhile mobile games development continues to be an area where we need to accumulate experience and strengthen capabilities.

Now let me discuss each of these in detail. First, for online games; our flagship MMO game, TLBB continued to make new records in revenues and attract a loyal following of players in the fourth quarter after the release of the major expansion pack New TLBB in late October. This major expansion pack with its completely redesigned graphics and brand new characters from the Tian Long plan appeal to TLBB's core audience and attracted returning players to play the game, but attracted fewer new players than expected.

Revenues for TLBB grew in the fourth quarter due to core players spending more on western upgrades and armory in the game. Currently, we are assessing feedback on New TLBB. In 2014 we plan to release three expansion packs including one major annual expansion pack to continue to upgrade the game to the latest trends, increase user stickiness and further expand the life span of the game. The next expansion pack which is a regular one will be released in April.

Second, our flagship web games Wartune and DDTank continue to enjoy extended popularity in China because of our ability to consistently enhance these games based on customer feedback. Wartune was affected in the fourth quarter by the typical seasonal downturn after students returned to school following the summer holidays.

The game grew in December after the successful release of Wartune II, a major new version of the game that added large scale cross over planned battles for advanced players and social elements from making friends and getting married within the game. We also saw growth of Wartune overseas in markets such as North America and Turkey.

DDTank continues to set records as the longest running major web game in China to-date. The game has entered into relatively mature phase. In the fourth quarter we added new game play and made enhancements to the game’s planned battle system to increase user stickiness and expand the game’s life span.

Third, in mobile games we launched our first in-house developed mobile game, TLBB mobile version and our first co-developed game Wartune mobile version in the fourth quarter. However, revenue from mobile games was still insignificant. According to data from the State Administration of Press Publication, Radio, Film and Television the size of China’s mobile games market more than doubled in 2013 to approximately $1.8 billion, accounting for roughly 13% to 14% of the overall online game market. This presents great opportunities for us to grow as well as new challenges to meet in our game development model.

In the coming year we expect competition to intensify in the mobile games market in China with greater levels of user segmentation and faster product lifecycles. If we want to capture market share and benefit from the growth of the mobile games market we will need to speed up our investment in mobile games to increase our chance of success.

In 2014 we will further invest in the in-house development of mobile games. We also plan to capitalize on the experience of top independent mobile game developers to jointly develop mobile games. In addition, we are establishing a major initiative for licensing mobile games from outside developers in China and abroad.

This licensing program which we call the Win Plan for developers builds on the rapid expansion of domestic game development studios within China as well as the huge numbers of game developers internationally. Many of these independent developers have enormous talent but are undercapitalized and lack the resources for marketing as well as game operations.

With our experience in both areas we can service partners to be independent allowing them to maximize their success in the market while we secure a variety of high quality mobile games to increase the number of successful mobile games we have and to capture market share. If you look at total numbers for our game pipeline in 2014 we have three MMO games, five web games and 10 to 15 mobile games set to come online during the year depending on the outcome of feedback testing and analysis.

Fourth, in our platform initiatives in the fourth quarter we successfully established multiple gateways versus access points to the platform built around 17173’s offerings. We launched a series of new software applications on the PC and mobile. As a result we saw significant growth in the average monthly active accounts of our platform channels which reached 149 million, an increase of 51% quarter-over-quarter and 93% year-over-year.

Ultimately our goal is for the site and the software applications to come together as complementary parts of a unified user platform to meet the various needs of today's online gamers.

Let me briefly highlight some of the software applications we had in operation launched or acquired in the fourth quarter. First, the 17173 browser which is an Internet browser designed for web game players that puts all the tools needed during the life cycle of game play conveniently within reach of users with a click of a button.

Second, game tool, a mobile app for searching and downloading games with comprehensive information about like such games like their launch dates, the number of new servers added, gifts, promotions, tutorials, tips, reviews and more.

Third 17173, mobile, which is a mobile app for games, news, browsing that is powered by the news content of the 17173 website. Fourth, 17173 video helper, which is a PC client software for recording, managing and watching live streams of videos of game-play and e-sports. Five, Raidcall, which is a high-quality group communication software used by professional gaming teams around the world for real-time audio and video chat. We acquired this asset as part of the acquisition of a majority 62.5% equity stake in the Raidcall business.

We carried out marketing campaigns in the fourth quarter for all of these software applications just mentioned as well as other software applications. Considering the encouraging user metric and intensifying competition we are seeing for our software applications and for our platform since we announced our plans build it we will continue to promote these software applications heavily in 2014 to capture as much user market as possible in the shortest possible timeframe.

Finally in light of our increasingly diversified online game operations and the use of platform initiatives that we are working on there is a need for better ways to motivate and reward employees that can directly tie their efforts with the company's growth over the long term. This is critical to our success as people are what drives our business.

As of December 31, 2013 we have over 6,000 employees of which 4,200 are engineers organized into project teams for initialing projects and competing with each other to build the most successful new games and apps. We plan to recruit another 1,000 engineers in 2014 for our platform initiative.

Yes, we are competing with heavyweights in the Internet industry for talent not just online game companies but also large Internet companies. In order to compete effectively for talent in such a heated market and to facilitate the management of a larger pool of employees over the long-term we announced today three new employee incentive plans with terms of 10 years under which the company will pay compensation to employees based on the profitability of the company or the net returns in a specific project.

We believe the implementation of these plans will grant employees a greater sense of ownership in the company and in their areas of responsibility and encourage an entrepreneurial culture within the company that in the long run will benefit our company and our shareholders.

Before I wrap up I'd also like to take a moment to thank Alex Ho, our CFO who will be leaving our company on March 4 to start his own business. He is played a significant role within the senior management team leading various key strategic acquisitions that have accelerated the growth of our business as well as managing the overall financial health of the company. I want to thank him for his extraordinary leadership and contributions to the company and wish him every success in his new pursuit.

Looking back 2013 was a turning point for us. The stability of our core businesses gave us the opportunity to raise our game in the fast growing mobile segment and build the foundation for our platform business. The performance of our core businesses has also given us the financial depth to support new ways to build our brand around our dedication to the needs of all our stakeholders, users, talent and shareholders.

This completes Tao's prepared remarks. Now let me turn the call over to our CFO, Mr. Alex Ho to walk you through the operational and financial highlights for the quarter.

Alex Ho

Thank you, Angie. Hello everyone. I'll now take you through our operations results for the fourth quarter.

Total average monthly active accounts for our games were 25 million, a decrease of 19% quarter-over-quarter and 34% year-over-year. The quarter-over-quarter decrease was mainly driven by a decline in active account of DDTank as the game has entered into a relatively mature phase and a decline in active account of Wartune in China.

The year-over-year decrease was mainly driven by a decline in active accounts of TLBB after the company closed down certain game accounts during the year, so as to further enhance the balance of the in-game economic systems; a decline in active accounts of DDTank as the game has entered into a relatively mature phase, and a decline in active accounts of Wartune in China.

Total average monthly active accounts of our platform channels were 149 million, an increase of 51% quarter-over-quarter and 93% year-over-year. The quarter-over-quarter and year-over-year increases were mainly due to the promotion, acquisition and launch of multiple software applications for PCs and mobile devices in the fourth quarter of 2013.

Let me move to discuss our financial results for the fourth quarter. One, revenues; total revenues were a record $194.9 million, up 6% quarter-over-quarter and 12% year-over-year and were in-line with our guidance. Online game revenue was a record $172 million, up 6% quarter-over-quarter and 9% year-over-year and was in-line with our guidance.

The quarter-over-quarter and year-over-year increase was mainly due to increased revenue from TLBB after the release of major expansion pack, new TLBB in the fourth quarter of 2013. Online advertising revenue was a record $16.9 million, up 3% quarter-over-quarter and 35% year-over-year and was in-line with our guidance.

The quarter-over-quarter increase was mainly due to an increase in advertising spending by game companies to promote their games in the fourth quarter of 2013. The year-over-year increase was mainly due to an increase in advertising rates of 17173 website during 2013. Internet value-added services revenues were $1.4 million up 28% quarter-over-quarter and 85% year-over-year.

The quarter-over-quarter increase was mainly due to the launch of new web games, and increased spending by players in some of the web games operated by the 17173 business in the fourth quarter of 2013. The year-over-year increase was mainly due to more web games and higher number of players playing web games operated by the 17173 business in the fourth quarter of 2013 compared with the same quarter last year.

Other revenues, which consist of cinema advertising revenues, were $4.6 million, up 14% quarter-over-quarter and 119% year-over-year. The quarter-over-quarter and year-over-year increase was mainly due to increased advertising sales due to improvement in the sales functions in the fourth quarter of 2013.

Now let me provide some more color about our other financials. From now on most of the figure discussed will be non-GAAP. As a reminder you can find a reconciliation of these non-GAAP measures in our official earnings release. Two, gross margins; non-GAAP margins was 82% compared with 84% last quarter and 84% in the same period last year.

Three, operating expenses; non-GAAP operating expenses were $130.1 million, 83% higher than last quarter and 158% higher than the same period last year. Both the quarter-over-quarter and year-over-year increases were mainly due to an increase in salary and compensation expense as a result of increased headcount and higher advertising cost for the promotion of software application for PCs and mobile devices of the platform business and the launch of major expansion pack, new TLBB and new mobile games. Four, operating margins; non-GAAP operating margins was 15% compared with 45% last year and 55% in the same period last year.

Five, income tax expenses; in December 2013 our main operating entity in China was approved as 2013 and 2014 Key National Software Enterprise and thus is subject to a preferential corporate income tax rate of 10% in 2013 and 2014. We had previously recorded income tax expenses for 2013 based on a corporate income tax rate of 15%. After adjusting for the tax refund anticipated from applying the lower new tax rate in 2013, income tax benefit was $7.7 million in the fourth quarter of 2013.

Six, net income; non-GAAP net income attributable to Changyou.com Limited was $43.3 million or US$0.82 per ADS on a fully diluted basis. These exceeded our guidance by $21.3 million mainly due to less marketing and promotion expenses spend on software application for PC and mobile devices of our platform initiative than what we had budgeted and a core of tax refund for the year 2013 in the fourth quarter.

Non-GAAP net income attributable to Changyou.com Limited for the fourth quarter was down 41% from last quarter and 43% from the same period last year.

Seven, net margin; non-GAAP net margins attributable to Changyou.com Limited was 22% compared with 40% last quarter and 44% in the same period last year. The decrease in the non-GAAP net margin was mainly due to higher operating expenses in the fourth quarter for the reasons explained already.

Next moving on the balance sheet and cash flow statements, as of December 31, 2013 we have a combined balance of cash and cash equivalents and short-term investments of $551.3 million, up from $525.6 million at the end of the third quarter of 2013. As of December 31, 2013, we had short term bank loans of $410.3 million and current and non-current restricted time deposits of $424.7 million, compared with short-term bank loans of $354 million and current and non-current restricted time deposits of $365.7 million at the end of the third quarter of 2013. For the fourth quarter we generated about $83 million in operating cash inflow.

Next, an update on our share repurchase program. As of December 31, 2013 we have used $17.3 million of the $100 million of authorized under the share repurchase program to buyback 590,500 ADS of the outstanding ADS. Please refer to the earning release for detail about our share repurchase program.

Finally, our outlook for the first quarter of 2013 is as follows: We expect one, total revenues to be between $174 million and $180 million of which online game revenues are expected to be between $160 million and $165 million. Online advertising revenues are expected to be between $8 million and $9 million.

The expected decline in online game revenues for the fourth quarter is mainly because of the projected lower revenues from TLBB, as we will not launch an expansion pack for the game in the first quarter. The decline in online advertising revenues from the fourth quarter is mainly because the first quarter is typically a seasonally slow quarter for the online advertising business.

Two, non-GAAP net loss attributable to Changyou.com Limited to be between $16 million and $22 million. We expect there to be a non-GAAP net loss attributable to Changyou.com Limited because A; we expect a decline in revenue as just explained. B; we will increase expenditure on marketing of software application for PC and mobile devices in China and overseas by approximately $20 million quarter-over-quarter, in order to build upon initial results of the marketing campaign we began last quarter. C; we will increase investment in human capital, hiring more and more engineers and offering more competitive salary and benefit packages.

We expect this to increase cost and expenses in the first quarter by approximately $13 million quarter-over-quarter. For the rest of 2014 we will continue to aggressively invest in new initiatives for the future, such as the platform business and the new mobile games, so as to increase our capabilities and improve our chance of winning new business opportunities and capture market growth potential.

Three, non-GAAP fully diluted net loss per ADS attributable to Changyou.com Limited between $0.30 and $0.40. Four, assuming no new grants of share-based awards, we estimate stock-based compensation expenses between $500,000 and $1 million, increasing our fully diluted loss per ADS attributable to Changyou.com Limited under U.S. GAAP by US$0.01 to US$0.02.

We ended 2013 with record revenues across each of our business lines in the fourth quarter. Our solid performance and rich cash inflow from our MMO and web gamed business provide us with capital to make aggressive investment in key initiatives such as mobile games and platform business. We look forward to these investments bearing fruit and helping us to capture the great opportunity ahead of us.

This concludes our prepared remarks. Thank you for joining the call today. Operator we will now open the call to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Alicia Yap from Barclays. Your line is open. Please go ahead.

Alicia Yap - Barclays

Good evening. Thanks for taking my questions. So actually can you elaborate a little bit more on the expenses? So was this loss making quarter a one quarter event or should we expect this to continue into the rest of 2014? And when should we start to see some of the spending to be more moderate? And I have one follow-up. Thank you.

Unidentified Company Participant

In the third quarter of 2013 our company published that we will be entering and pursuing a platform strategy and that we will begin to put invest more in the development and the marketing of platform products. Because of our solid execution of our platform strategy we've had good results in the aggregate monthly active accounts of our platform channels, which reached 149 million, an increase of 51% quarter-over-quarter as such. Due to the effectiveness of this marketing campaign we plan to continue it into the rest of the year. Thank you.

Alicia Yap - Barclays

Okay. So my follow-up question is these MAU for the platform user, so if you could share with us some of this $50 million sequential incremental increase where do they come from and which platform given that you promote several platforms, so which platform actually gained the most new user during the 4Q? And can I clarify, in 3Q your $99 million was that mainly on the 17173 PC side only in 3Q? Thank you.

Unidentified Company Participant

First of all regarding the question about the third quarter MAU platform channels, it includes both the MAU of our -- on the PC and on the mobile devices and the calculation method is the same in the third quarter as well as in the fourth quarter.

And the marketing that we did on our software applications was done as a portfolio of the products that we launched and most of the increases surrounding the new platform products of 17173, including 17173 mobile, the 17173 Internet browser and also Raidcall. Sorry to clarify the Raidcall, the MAU of Raidcall was not included in the statistical counts of our MAU in the fourth quarter. Thank you.

Operator

Your next question comes from the line of Eddie Leung from Merrill Lynch. Please go head.

Eddie Leung - Bank of America Merrill Lynch

Thank you for taking my call. I have two questions. The first one about marketing strategies. Could you give us most accurate examples on how you are going to promote your various platforms or choose to attract users as the increased expenses seem to be pretty high? So that's my question number one. And then secondly, could you also give us any guidance on how big do you expect your mobile games revenue would be in next say 12 to 18 months? Thanks

Unidentified Company Participant

As we just started -- as we are just in the beginning stages of promoting our platform products we currently do not have any plans to release any detailed information about our marketing strategy. In the fourth quarter approximately 80% of the marketing expenses were spent on the promotion of our platform products. This will continue for an extended period of time.

Right now we have not completed the plan for or estimates of how large mobile game revenues will be at the end of this year, because the success of a game is dependent on many factors and there are many changes to whether a game is successful. We currently are developing over 30 games and in this year we plan to increase the number of games that we have in our pipeline for future releases to 50 games.

We plan to select the best performing games within that 50 games I mentioned and select approximately about 10 to 15 games to launch in this year and the amount of revenues that we’ll generate from these newly launched games will be largely dependent on how well these games perform after launch.

In addition, we plan to launch five web games and three MMO games in order to make sure that MMO and web game business continues to grow steadily. Thank you.

Operator

Your next question comes from the line of Evan Zhou from Credit Suisse. Please go ahead.

Evan Zhou - Credit Suisse & Co.

Hi, good evening. Thanks for taking my questions. I have two questions. First one is on the three new employee incentive plans that you have just now. Could you maybe elaborate it bit more how does these plan works and what are the differences between these plans? How will the company look at the specific metrics on profitability and performance metrics to further incentivize the employee? And I have a follow-up. Thanks.

Unidentified Company Participant

The first plan is called the Company-Wide Plan. The Company-Wide Plan is given to employees based on the number of years that they serve at Changyou. In order to -- this is to make sure that every employee that service -- that stays in Changyou for a sufficient period of time can also benefit from -- and benefit from the company's growth and get returns in compensation. The total pool of the plan will not exceed 5% of the annual adjusted net profit of the company.

The second one is called the Full Responsibility Plan. This is mainly --the compensation under the employees under this plan is in essence dependent upon the employees' job responsibilities and their contributions for the company. The way in which the compensation is distributed is somewhat similar to the -- a similar plan put out by Huawei. Similarly under this plan the total amount distributed by the company will not exceed 5% of the company's annual adjusted net profit.

And the third plan is essentially in essence a plan to distribute profits of projects within the company and under this plan we will not distribute an amount exceeding 20% of the net profits of the specified projects. And the only differences that I know these -- on the points for these plans that is made and it is structured as kind of a virtual stock plan using employee incentive instruments. And this will also take into consideration the fact that there would be changes to the teams of projects over time.

We believe the launch of these three new incentive plans will greatly increase employees' diligence in the work and also increase their sense of ownership, and also encouraging entrepreneurial culture within the company and increase the profit of the company as well as the benefits to returns to shareholders. Thank you.

Evan Zhou - Credit Suisse & Co.

Thank you. That's very helpful. And my second question is on our plan and effort to transform the company's platform. I am wondering what are the major KPIs that we'll be tracking or look to evaluate the progress of this kind of platform migration. Is there any target that we'll be looking at say at what level that would be probably normalized our spending or and also do we have any target on the international side of this platform migration, any kind of metric for profit that would be very helpful. Thanks.

Unidentified Company Participant

The company is not in a process of transforming its business but we are in the process of building new products to -- like to start-up the company. The amount of time that we spend day-to-day on building our platform business is over 80%. And in terms of our online games business over the many years that we've been doing it we've build very good teams to run this business.

Our main KPIs for our platform business is MAU, which is the Monthly Active Accounts as-well-as our user penetration within specific markets. For us we are more focused on the opportunities globally. Thank you.

Operator

So our next question comes from the line of Alex Yao from JPMorgan. Please go ahead.

Alex Yao - JPMorgan

Hi, good evening, everyone. Thank you very much for taking my questions. I have two questions. Number one is on the PC gaming revenue side, if we look at the fourth quarter operating metrics for two core web games DDTank and Wartune declining by usage especially in China because they are moving to a relatively late stage of their life cycle and also TLBB declined on year-over-year basis because this game is also maturing. So for 2014 what game will drive your PC gaming revenue growth?

The second question is on your platform investment strategy this year. We understand it's going to be a -- it's going to last for an extended period of time. So by the end of this year what kind of milestone are you looking at, what kind of achievement do you want to accomplish by the end of this year? Thank you.

Unidentified Company Participant

First of all regarding our two web games, DDTank and Wartune even though overall within the industry web games tend to have a short-term life spans, however for DDTank and web games we are continuing to extend the life span of these games and when we develop the games we are focused on the long term benefits from the games. As such we believe that these games we will continue to monitor and we’ll be able to continue to grow these games hopefully.

And during the year we expect TLBB to continue to grow year-over-year. It is only that in the first quarter you see it decline because we do not plan for launch any expansion packs in the first quarter.

And our game studio 7Road will be launching two key web games this year. One is called Deify's Crown, the other one is called Shadow Sword and both of the games will be launched in the first half of 2014. And in addition they have mobile games environment they are also working on a shooting game that we will launch this year. And we will also launch three MMO games, including Asta, Echo of Soul and Fantasy Frontier, online. We hope that one of these games will be successful.

We did an analysis on the MAU statistics published or given by various platform companies and based on our analysis we believe that after a company’s MAU exceeds 300 million you will see a significant growth in that company’s platform. Because our number of users are distributed across several different products we will actually need an even larger -- to reach it even larger number of users in order for our user platform to become of greater value. Thank you.

Alex Yao - JPMorgan

Can I ask a very quick follow-up question so for the platform MAU target let’s say 300 million maybe by the end of this year or maybe by the end of next year, if you achieve that target is it mainly coming from the Chinese market or that will be spaced between China and international market. Thank you.

Unidentified Company Participant

The 300 million MAU number that I mentioned is our company's long-term plan. We actually do not have any plan or KPIs for the end of this year or the end of next year. Our team is continuously tracking our progress on the execution of strategy and currently we do not don't do plans of exceeding three months.

Basically for most of the product, the product positioning for our current platform products is aimed at the global market. We typically will do the English version first and then we will launch other various language versions. And we are focused on bringing these products to users globally.

We are still in the process of capturing opportunities in the market. So we do not have a very, very long term extended plan for this at the moment. Thank you.

Alex Yao - JPMorgan

That's very helpful. Thank you very much.

Operator

This is the end of our Q&A session. I will now hand it over to our speakers for any additional remarks.

Angie Chang

Once again I would like to thank you for joining today's call. If you have follow-up questions, please contact us. Thank you.

Operator

That does conclude our conference for today. Thank you for participating. You may all disconnect.

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