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

Q1 2010 Earnings Call

May 17, 2010 8:00 am ET

Executives

Vivien Wang – IR Officer

Michael Chi – Founder, Chairman and CEO

Kelvin Lau – CFO

Analysts

Alicia Yap – Citigroup

Lisa Yuan – Morgan Stanley

Wallace Cheung – Credit Suisse

Eddie Leung – Banc of America

Atul Bagga – ThinkEquity

Wendy Huang – RBS

Andrey Glukhov – Brean Murray

Adam Krejcik – Roth Capital Partners

Jin Yoon – Nomura

Ming Zhao – SIG

Tian Hou – Auriga

Operator

Thank you for standing by, and welcome to the Perfect World quarter one 2010 earnings conference call. At this time, all participants are in listen only mode. There will be a presentation followed by a question-and-answer session. (Operator instructions) I would now like to hand the conference over to your speaker today, Vivien Wang. Thank you. Please go ahead.

Vivien Wang

Thank you, operator, and thank you, everyone, for joining us today for Perfect World’s first quarter 2010 earnings release conference call. We distributed our unaudited earnings release earlier today. You may find a copy of the press release on our official web site or through the newswire.

Today, you will hear from Mr. Michael Chi, our Chairman and CEO, who will give us a brief introduction and overview. Mr. Kelvin Lau, our CFO, will then discuss some of our latest business and operational developments and take us through our financial performance in the fourth quarter of 2009. Following the prepared marks, Mr. Chi, Mr. Lau and I will be available to answer your questions.

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

Perfect World does not undertake any obligation to update any forward-looking statements as a result of new information, future events or otherwise, except as required under applicable law. Our earnings release and this call include discussion of certain non-GAAP financial measures. Our earnings release contains a reconciliation of the non-GAAP measures to the most directly comparable GAAP measures. And it’s available on our Web site, at www.pwrd.com under the Investor Relations section.

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

Michael Chi

Thank you, Vivien, and thanks everyone for joining us today. We are pleased to announce our first quarter results. Our results came in line with our previous expectations as our games continued to perform well.

This quarter we experienced some technical complications during the major updates on our recently launched new game, but have solved the problems and working on our soon to be launched major extension pack with a lot of enhanced content to further drive the user base. This experience was valuable for us as we learnt how to avoid similar issues in the future development of both new and the existing games.

Despite this occurrence and the adverse seasonality factors, we continued to increase the popularity of some of our existing games to deliver sequential growth. We are further strengthening our game development capabilities by continuing to invest in our R&D team. By doing so, we are able to deliver a strong and sustainable pipeline of notably differentiated games that span 3D, 2.5D, and 2D market segments.

We continue to host specialized game engines and production studios that allow us to remain highly competitive as we build franchise that includes flagship titles in each of these market segments.

Overseas expansion continues to progress, and we're quite satisfied with the development so far. We continued strength in our worldwide penetration by signing new licensing agreements with various overseas game operators. Our US operations are also progressing well as we recently launched Battle of the Immortals in North America through a wholly owned subsidiary in the US.

We have seen very positive feedback since its launch. Furthermore in April we acquired C&C Media Co., Ltd., our long-term Japanese operation partner to capture the growth opportunities in Japan and to further expand our overseas operating capabilities.

As part of our growth strategy, we continuously monitor the market for acquisition opportunities that will generate synergies with our core business. Recently we have some new developments on this front that I am excited to announce. We made strategic investment to acquire a majority stake in Runic Games, Inc, a top tier game development studio based in the US to further strengthen our R&D capabilities.

By working closer with this professional team we see to create global titles by combining their creativity and expertise in game development with deep understanding of the online game market.

We also exercised an option to increase our stake in Chengdu Ye Net Science and Technology Development Co. Ltd. a web game developer and operator. Through enhanced control, we believe we will have greater flexibility to generate valuable synergies between the web game business and our core business. We are well positioned to capitalize on the various prospects and opportunities the industry presents.

As we continue to dedicate our strong resources to long-term projects, we aim to effectively lengthen the life cycle of both new and existing games that meet the expectations of gaming players around the world. As always our management team is focused on the long-term and is committed to driving the sustainable growth of our company while increasing value for our shareholders.

With that, I would like to pass the call to Kelvin.

Kelvin Lau

Thank you, Michael. This quarter we rolled out two expansion packs including The Joyous Bunch for Fantasy Zhu Xian and When Fairies Encounter Devils for Perfect World II. And following the end of the quarter we launched Drum Your Heart Out for Hot Dance Party, and The Rookie and the General for Chi Bi.

In terms of our overseas development, during the quarter we signed an agreement to license Battle of the Immortals to Korea. Following the end of the quarter, we also signed agreements to license Battle of the Immortals and Hot Dance Party to Russian federation and other Russian speaking territories.

Post the quarter end, we also had a couple of overseas launches that are encouraging. As Michael mentioned earlier, we recently launched Battle of the Immortals in North America through our wholly owned subsidiary. We also launched Pocketpet Journey West in Korea, through our Korean partner.

Now, I would like to take you through to our first quarter 2010 financial highlights. Our total revenues were RMB 625 million in 1Q '10, an increase of 2.8% from 4Q '09 and 47% from 1Q ‘09.

Our online game operations revenues were RMB 569.7 million in 1Q '10, up 5.2% from last quarter and 51% from 1Q '09. The sequential growth was primarily attributable to the continued popularity of some of our existing games and a series of successful in game promotions and marketing activities.

ACU for games under operations in Mainland China was approximately 993,000 in 1Q '10, as compared to 1.1 6 million in 4Q ‘09 of 615,000 in 1Q '09. APC for games operated in Mainland China under the item based revenue model was approximately 1.67 million in 1Q '10. That is compared to 2.19 million in 4Q '09 and 1.46 million in 1Q '09.

ARPU of games operated in Mainland China under the item based revenue model was RMB 360 in 1Q '10 as compared to RMB 223 in 4Q '09 and RMB 244 in 1Q ’09. ACU and APC decreased by 14.2% and 23.7% respectively from 4Q ’09 mainly due to some technical complications that occurred during some major updates on our recently launched new game as well as the adverse seasonality factors and more aggressive anti-cheating efforts that we adopt.

However, we still managed to increase ARPU by 37.2% from 4Q ‘09 through a series of successful promotions.

Our overseas licensing revenue were RMB 53.4 million in 1Q ’10, as compared to RMB 61.7 million in 4Q '09 and RMB 48 million in 1Q '09. The decrease from 4Q ’09 was mainly attributed to a decline in usage based royalty fees due to adverse seasonality in certain overseas markets, as the decrease in initial license fees as we did not commercially launched any games in overseas market in 1Q ’10.

Our film, television and other revenue were RMB 2 million in 1Q ’10, as compared to R&B 4.5 million in 4Q ’09 (inaudible) in 1Q ’09.

Our gross margin stayed at very healthy 86.1% in 1Q ’10. This was roughly in line with 86.6% in 4Q ’09, and 86.7% in 1Q ’09. Our online game related cost increased from 4Q ’09 mainly due to increase in staff related costs and depreciation expenses.

You will notice that our operating expenses decreased 14% from 4Q '09, but increased 55.3% from 1Q '09. The decrease from last quarter was mainly due to the following factors. Number one, an RMB 42.5 million decrease in sales and marketing expenses. This was largely due to lower advertising and promotional expenses as we did not launch any new games in 1Q '10. In addition, the decrease from 4Q '09 was also attributable to the special charges of approximately RMB 17.5 million in 4Q '09, associated with a change in the estimated usable life of certain intangible assets acquired from InterServ, which are related to outsourcing services.

Number two, an RMB 0.9 million increase in R&D expenses primarily due to an increase in staff cost as we continued to increase our R&D talent pool. Number three, an RMB 6.5 million increase in G&A expenses mainly due to an increase in professional service expenses.

Our income tax expenses was RMB 28.7 million in 1Q '10 as compared to RMB 17.5 million in 4Q ‘09 and RMB 19.9 million in 1Q '09. Beijing Perfect World Software Company Limited or PW Software, our wholly owned subsidiary, has qualified as a high and new technology enterprise, and was entitled to a tax exemption in 2007, 2008, and 2009 and enjoys a 50% reduction of this applicable corporate income tax rate in 2010.

The corporate income tax applied to PW Software in 1Q '10 caused us to increase in income tax expenses from 4Q ‘09. If PW Software continues to be qualified as high and new technology enterprise 2010 to 2012, we will continue to be entitled to 50% reduction of this applicable corporate income tax rate from 2010 to 2012.

Net income attributable to the company’s shareholders was RMB 305.2 million in 1Q '10 as compared to RMB 270.8 million in 4Q '09 and RMB 215.4 million in 1Q '09.

Non-GAAP net income attributable to the company’s shareholders was RMB 327 million in 1Q '10 as compared to RMB 292.8 million in 4Q '09 and RMB 230.9 million in 1Q '09.

Basic and diluted earnings per ADS were RMB 6.12 and RMB 5.75 respectively, in 1Q '10. This compares to RMB 5.44 and RMB 5.09 respectively in 4Q ’09, and RMB 4.14 and RMB 3.96 respectively, in 1Q ‘09.

Non-GAAP basic and diluted earnings per ADS were RMB 6.56 and RMB 6.16 respectively in 1Q '10, as compared to RMB 5.88 and RMB 5.5 respectively, in 4Q ‘09 and RMB 4.43 and RMB 4.25 respectively in 1Q ‘08.

In terms of financial guidance based on our current operations, total revenue for second quarter of 2010 are expected to be between RMB 594 million to RMB 625 million, representing an increase of 14% to 20% on a year-over-year basis, and a flat to mild decline on a sequential basis. In order to lengthen the life cycle of our existing games to maintain sustainable growth, we decided to decelerate some of the in game promotions and monetization activities in the second quarter to further nurture our games and grow the user base.

In addition, this also reflects the impact of suspending game services in response to one day national mourning for earthquake victims.

With that, now I would like to turn back the call to Vivian.

Vivien Wang

Thank you, Kelvin. This concludes the prepared remarks for today. We are happy to take your questions now. Operator, we're ready for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Alicia Yap of Citigroup.

Alicia Yap – Citigroup

Hi, good evening Michael, Kelvin and Vivien, I have two questions. First of all, could you help us understand the rationale behind why you decided to acquire a majority stake in Runic Games? And how much additional R&D costs should we expect to increase starting in the second quarter? With the continued investment in R&D and sales and marketing, are you still comfortable of maintaining your operating margins of between 45% to 50%?

Kelvin Lau

(Foreign Language)

Michael Chi

Alicia, thank you. First of all, the Runic team, I think we mentioned it before, the team members of Runic; they’re already experienced game developer. They had already accumulated lot of – many years of game development experience I think in US. So basically they are very good team. We love to cooperate with this type of good team. We also mentioned it last year, they also launched a PC single base version, Torchlight in US and then the big bet of this PC single version based games were positive in US.

So we can foresee that I think we really can have a bigger achievement and success in US. So I think this is the key reason why we decided to increase our stake – or started to invest in Runic in the longer term I think is beneficial to the whole group going forward, and also we really want to increase some of our different type of western style game portfolio, going forward to further explore our international market going forward, number one.

After we increased the stake in Runic, yes we are going to consolidate final sustainment of Runic after we increase the – after we become the majority shareholders of Runic. This will increase a little bit on R&D expenses, why, because we have to consolidate the financial statement, but for Runic right now the team is quite small. So the impact on R&D expenses with the very minimal.

Very importantly I think Runic right now is making profit right now after they launched the PC single base version of the game Torchlight. So regarding your last question, the operating margin, I think the impact from Runic, I think regarding the R&D expenses will be very minimal [ph] on our financial statement. So we tried to keep our operating margin, but we are going to have new game launch in the second half of this year. So I think the major impact, I think will be on the sales and marketing expenses in the short run, yes.

(Foreign Language)

Vivien Wang

One additional point, comments from Michael because after the launch of the single player version of Torchlight by Runic, they’re actually profit-making by themselves. So we would expect that the profit that they make from the single player version will cover the R&D costs. Yes, thank you.

Alicia Yap – Citigroup

Okay can I just follow up on that? So your acquisition price on the RMB 8.4 million is including the profit that they already generated?

Kelvin Lau

No, no, no. I think we cannot take the profit. I think before we acquired 70% of this stake, (inaudible) have profit Alicia.

Alicia Yap – Citigroup

Okay, all right. I actually have the second question. So, given what has happened over the past 12 months, and if we were to look back, what are the things or steps that you wish you could have done to avoid some of the earnings volatility over the past year? And did you have any regrets on any of the R&D team acquisitions? And what are the steps that you are planning to implement to ensure a more stable and sustainable earnings growth going forward?

(Foreign Language)

Vivien Wang

One thing actually we think we could have done better is with the quality control over our new game, Fantasy Zhu Xian, because Fantasy Zhu Xian is our first 2-D based game developed by our new team based on new engine. So actually – during – in the past few months during the updates, some of the major updates we experienced some of the programming bugs or deficiencies, but we have already fully solved all of those problems, and we have a major expansion pack to be launched soon to aim to further drive the traffic, and we learned a very good lesson from this. Going forward, we will talk more, strict control in terms of the – on the quality control all our games before the launch to avoid similar issues.

Alicia Yap – Citigroup

Thank you very much Vivien and Michael.

Operator

Your next question comes from the line of Lisa Yuan of Morgan Stanley.

Lisa Yuan – Morgan Stanley

Hi Michael, Kelvin and Vivien, good evening. Thanks for taking my question. My question is regarding your second quarter guidance. In your current guidance have you budget in the revenue contribution from your new game, Forsaken World? And which game has led to the sequential revenue decline, and can we expect the revenue to recover?

Michael Chi

In my guidance I think for Q2 we didn’t take into account any revenue from Forsaken World. So Forsaken World game right now we are undergoing the technical testing and small-scale closed beta testing. So we have planned to launch the game in Q3 this year. So we didn’t see any revenue from – to be generated from forsaken world in Q2. In fact, what I said is, I think we mentioned in our prepared remarks saying that we are going to decelerate the monetization activities in games, especially for Perfect World II (inaudible) in Q2.

So I think these two games we will experience a little bit decline in Q2. I think the major purpose I think is what we mentioned; we wanted to prolong the game life of these two (inaudible) in our game portfolio. So we are looking for more long-term sustaining the growth for revenue to maintain these two games, and also of course POI is also very stable right now and also tried to achieve (inaudible) plus our new game the launch. So we are confident that in going forward we can maintain some sustainable revenue growth, starting from the second half of this year.

Lisa Yuan – Morgan Stanley

Then Kelvin I have a follow up. So can you give us an update on your 2010 pipeline? Are you still going to launch Dragon Excalibur in third quarter, and another game in fourth quarter?

(Foreign Language)

Vivien Wang

Actually, because we recently launched Battle of the Immortals model in some of the overseas market and the feedback is very positive. So we realized that actually a western style game can be well accepted in many of the Western markets or overseas markets in general, and given this sales, we decided to postpone our game Forsaken World a little bit to further beef up the content, because this is our first 3D Western style game.

So we really want to make sure to beef up the content, to ensure the quality of the game before the launch to target a global audience. And for another game Dragon Excalibur similarly because we want to further beef up the content, we are targeting to launch the game in Q4, and for another (inaudible) game we are planning to launch the game in either 4Q this year or 1Q next year depending on the development status because the market is getting a lot of more competitive. We really want to make sure to ensure the quality of the game before the commercial launch. Thank you very much.

(Foreign Language)

Operator

Your next question comes from the line of Wallace Cheung with Credit Suisse.

Wallace Cheung – Credit Suisse

Hi Michael, Kelvin and Vivien. Just quickly on the second quarter guidance, how do you expect the performance of the overseas market? Can you also give us an update about the US and the European market performance in the first quarter and then also in the second quarter? Thank you.

Kelvin Lau

(Foreign Language)

Michael Chi

Hi Wallace, the answer to your question is in Q2 we expect the overseas licensing revenue will go down a little bit, why because as I said [ph] we just acquired C&C. Starting from first of April when the deal was closed, we got to tick up the whole financial statement of C&C and consolidate into our financial statements. So you’ve got to take out the royalty income included in the overseas licensing revenue line [ph].

Starting in Q2 all the revenue generated by C&C will be put in the online operation revenue. So we are talking about the overseas operating – overseas licensing revenue. I think one of the reasons for the decline is C&C because of the reclassification of the accounting treatment. And another one is in Q2 we do not have any games to be launched in all those major market.

So far we still haven’t heard any news from our operator, even though recently we signed some licensing agreement with Russian operator and also Korean operator. We still haven’t heard any news that they will commission to launch the game in Q2. So these two factors altogether come up with roughly I think a slight decline in the overseas licensing revenue for Q2. This is what we estimate.

Regarding US, I think pretty good, very stable. In Q1 we don’t have any new game launched in US. We are still operating four games in US. Recently we just launched Battle of the Immortals in US. So in Q1 US operation, the performance is still very stable. I think what I will say quite similar to that you saw in Q4 last year. So Battle of the Immortals launched in US, I would expect in Q2 we are going to see some better performance, better performance for US in Q2 because of the Battle of the Immortals, we just launched and also we mentioned in the prepared remarks; the feedback is quite good, Battle of the Immortals in US.

For our operation in Europe, in Q1 we just registered our company in Amsterdam in Europe, in Holland. And US office still hasn't started operation right now. We rent an office. We are looking for people in Europe. So right now we forecast, I think in European office we will start the operation in Q3.

Wallace Cheung – Credit Suisse

Okay, thank you. Just quickly, if we're excluding all these international business fluctuations, how do you actually see the second quarter core domestic business performance on a Q-on-Q basis? Thank you.

Vivien Wang

(Foreign Language)

Michael Chi

Wallace, I think we mentioned in the prepared remarks that in China, and in the domestic market I think in order to make sure that we can prolong or maintain the game life cycle for certain games, we decided to decelerate a little bit on monetization activities for existing games. So we expect in Q2 our revenue generated from our existing games in the China market will decrease.

Wallace Cheung – Credit Suisse

Okay, thank you.

Operator

Your next question is from the line of Eddie Leung of Banc of America.

Eddie Leung – Banc of America

Good evening Michael, Kelvin and Vivien. Just to follow up on your comments about monetization. Could you talk a little bit about the ARPU increase in the first quarter? And whether there would be any associated risk with the pretty significant increase in ARPU? Thanks.

Vivien Wang

(Foreign Language)

Michael Chi

Hi, Eddie. Thanks for your question. Yes, our ARPU in Q1 increased to 302 compared to Q4 last year, 223, an increase of about 37%. So I think the major reasons for this type of increase is in Q1 we did quite a lot of monetization for Perfect World II, in Q1. This is question number one. Number two, during the Chinese New Year, that is what we mentioned, I think Q1 is not a very good season for our 3-D games because most of the gamers in all those tier 1 and tier II cities they will be engaged in some other social activity during Chinese New Year and quit from the game for a while.

So, you can see our APC number dropped, and also I think this is the key reason why our ARPU go up quite a lot in Q1. And the third reason is, Fantasy Zhu Xian, I think in Q1. We launched Fantasy Zhu Xian in Q4 of last year. Going into the second quarter after the initial launch, the ARPU will go up, as well as I mentioned in the last earnings call, before the new game launch in the first quarter, I think after the initial launch, the ARPU was a bit lower, because the gamers are still stayed at a low level.

I think they will spend lesser in the games. When they are promoted to a higher level they will spend more. So ARPU will push up a little bit (inaudible) in Q1.

Eddie Leung – Banc of America

Understood. I also have a follow-up question on your technical strategies. Could you share with us how many game engines you are working on right now? And should we expect the number of game engines to expand going forward, given you are acquiring new studios and new teams? And how you guys can manage the complexities of different game engines. Thanks.

(Foreign Language)

Vivien Wang

Actually, we have at least four sets of engines and platforms which take care of our different type of games, for example 3-D games, 2.5 D games, 2 D games, and 2-D term based game. And for each of the engines and platforms, we actually have a specialized team, a programming team, to keep updating them and support the design team to design a different type of game, based on our proprietary engines and platforms.

Just now, as Michael mentioned, we made some mistake for Fantasy Zhu Xian, but it is not a mistake it terms of technology or deficiency in terms of technology itself, it is more because of the mistake of the process management, problem with the process management. Going forward, we believe, if we can put more effort on the quality control before the game’s launch to further streamline the process before our game’s launch, we believe we can avoid some of those issues. Thank you very much.

Eddie Leung – Banc of America

Right then. Thanks.

Operator

Your next question comes from the line of Atul Bagga with ThinkEquity.

Atul Bagga – ThinkEquity

Good morning. Thanks for taking my call. Michael, Kelvin, a couple of quick questions to you. So I understand your rationale why you want to reduce the monetization in second quarter in order to lengthen the life cycle of the games. Can you talk about the rationale why did you guys – why were you guys so aggressive in 1Q regarding monetization? That's the first question.

Kelvin Lau

In fact, for the monetization work I think we implement – execute in Q1 is already plentiful I think in Q4 of last year because Chinese New Year is a good excuse or a good festival timing for us to do some monetization. So every year we do some monetization in the Chinese New Year, even though some of the gamers I mean quit from the game for a while, but I think some low gamers still stayed in the game, and they were more willing to spend monies during Chinese New Year on the game.

So, yes, we just stick to our plans – plan in Q1 to do some monetization. But eventually when we find out that ARPU went up quite a lot in Q1, so I think this is the right moment for us to think about stop a little bit the monetization in Q2 in trying to prolong the game life cycle for the games to look for longer term sustainable growth in terms of revenue.

Atul Bagga – ThinkEquity

That makes sense. Second, can you talk about the decline in your ACU and APC number in one quarter? It seems like ACU went down almost 160,000 from Q4. Can you talk about what percentage of this decline came because of Fantasy Zhu Xian, and what was the other reason for the decline? And then how long will it take for Fantasy Zhu Xian to come back to the place [ph] you have seen.

Kelvin Lau

Yes, the decline in ACU number in Q1 is mainly due to the decline in ACUs for Fantasy Zhu Xian. If you look at – if you look back last year Q1 you will see we also experienced a decline in ACU number during Q1 because of the Chinese New Year. Last year, our ACU – Q1 last year our ACU number was only 619,000 compared with Q4 ’08 our ACU number was about 690,000, decreased about 10% to 11%.

So in Q1 this year, yes, I think the decline (inaudible) because of the Fantasy Zhu Xian. But we did a very good job for our other existing games. We will just look at Fantasy Zhu Xian, yes, about 10% of the decline in ACU number for Q1 this year. But if you just take out the decline in Fantasy Zhu Xian in all existing games the decline in ACU number is much, much lower than last year Q1.

That means the performance of our existing – all the other existing games like Fantasy Zhu Xian [ph] was performing pretty good in Q1.

Atul Bagga – ThinkEquity

And Kelvin, how long will it take for Fantasy Zhu Xian to come back to the level that you have seen –?

Kelvin Lau

Yes, that is what we have already mentioned, we are going to have expansion pack for Fantasy Zhu Xian this quarter, and also as far as (inaudible) we have already fixed all the technical issues, and also we are already for this treatment, our internal process for all those expansion packs, and also some – and all those technical updates for our games.

So, hopefully, I think after we launched the expansion pack together I think we're going to do more promotions. In all those small cities we are ramping up our (inaudible) right now. So we're trying to see some impact in terms of ACU for Fantasy Zhu Xian starting from June. This one we hope to see I think after we launch the expansion pack.

Atul Bagga – ThinkEquity

I'm sorry, so the expansion pack launch is in June?

Kelvin Lau

May, I think late May.

Atul Bagga – ThinkEquity

Okay. Perfect. Thank you.

Kelvin Lau

You are welcome.

Operator

Your next question comes from the line of Wendy Huang of RBS.

Wendy Huang – RBS

Thank you for taking my question. First, you just mentioned that Fantasy Zhu Xian's ARPU kept going up in Q1. So have you seen – is ARPU reached a stable level, and what's the current ARPU level for Fantasy Zhu Xian?

Kelvin Lau

You mean, right now, the ARPU for Fantasy Zhu Xian I think is pretty stable, pretty stable.

Wendy Huang – RBS

So what's the current ARPU level for Fantasy Zhu Xian?

Kelvin Lau

Wendy, sorry, I think our policy is not to disclose ACU number, APC number or ARPU number for individual games. But I think what I can disclose to you right now the ARPU number for Fantasy Zhu Xian is quite stable, because we up to now we still haven't– I think so far we still haven't (inaudible) of doing a lot of monetization for Fantasy Zhu Xian. Our priority is trying to ramp up the ACU user base first. So, we dare not to do a lot of monetization for Fantasy Zhu Xian at this stage.

Wendy Huang – RBS

Okay. So for most of the games that you plan for 2010, it seems that you delayed those games' launch for either three or four months, so what's the current average development cycle for your new games? And what's average R&D cost that you spend on those games?

(Foreign Language)

Vivien Wang

According, for our new game, the average development cycle is about 1.5 to 2 years, and the average development cost is about 40 million RMB.

Wendy Huang – RBS

Okay. My final question is regarding your C&C Media acquisition. You mentioned that currently that company already operates four of your games. Could you maybe give me some sense about those four games' revenue size, and how should we look at the valuation of those $21 million you spent on that company?

(Foreign Language)

Kelvin Lau

Yes, Wendy, yes, C&C right now they are operating six games in Japan. I think of this six games, four games are from Perfect World, including Perfect World II, Chi Bi, Zhu Xian, Legend of Martial Arts, these four games. So, and also another two Korean games, one is (inaudible), and Tartarus Online [ph], two Korean games.

Right now in this six game portfolio Perfect World II is performing the best, followed by a Korean game called Tartarus. So, our policy is not – I think the same the thing in China, we are not going to disclose for competitive reasons the ACU number or more details on each game’s performance operated by C&C now. I hope you can understand Wendy.

Wendy Huang – RBS

But if we look at – if we compare the – your acquisition price of C&C with Perfect World's own valuation, would you say that this acquisition dilute your valuation or not?

Michael Chi

I can say the valuation is lower; it is cheaper than Perfect World given our share price is going down right now. So, in fact, C&C is making profit I think in the past two years. So I think the most important thing is I think the team is good. They are very experienced I think on operating games in Japan. We are happy to co-operate with C&C, I think because they are our on long-term partner in Japan, we totally agreed, we fully agree upon and also understand what they are doing, and also the performance what we can see is excellent.

So that is the key reason why we decided to acquire C&C, and also Kevin mentioned, I think international expansion is one of our key strategies. So Japan is very potential, I think in terms of online gaming market I think it is very potential. So we are optimistic with Japan on the gaming market, by going to Japan I think we can earn more, and also we can open more opportunities to cooperate with all those Japan content providers and also some maybe R&D team in Japan, yes.

Wendy Huang – RBS

Sorry, I just record more question regarding your overseas expansion. Tencent [ph] recently invested in a Russian company DST and if I remember correctly, that company also operates one of Perfect World's games. So what kind of action will you take in the Russian market to defend your market share there?

Vivien Wang

Wendy, can you repeat your latter part of the question?

Wendy Huang – RBS

Yes, I just mentioned that Tencent invested in DST, which also operates one of Perfect World's games. So what kind of action will you take to expand into Russia to defending your market share there?

(Foreign Language)

Michael Chi

First of all, our DST is not, I don’t want to give any operator in Russia, I mean, our game operator in Russia. In fact, DST should be the shareholders of Mail.Ru, and Mail.Ru recently acquired Astrum. In fact, Astrum is the game operator, Perfect World’s game operator in Russia.

In fact, so far only one – only Perfect World II was launched in, has already been launched in Russia so far. So, here, I'm not going to give any comment I think on our good friend, Tencent, and their investment in DST, but I think regarding the Russian market, same as in Japan we are quite optimistic with the Russian market, in terms of revenue contribution right now, Russia is already ranking number 2 to number 3, I think in our overseas revenue contribution portfolio already.

So we are optimistic with the Russian market. In fact, we have been actively talking to Astrum and some other Russian operators. We are going to launch more games in Russia and also Russian, the mobile operators, they are very interested in Perfect World’s game. So, I think, very shortly I think you will see us adding some more Perfect World’s game will be launched in the US.

I think at least – at least at this stage, our strategy is to try to increase our market share by launching more of Perfect World’s games in Russia to increase our market share in Russia.

Wendy Huang – RBS

Thank you.

Operator

Your next question comes from the line of Andrey Glukhov of Brean Murray.

Andrey Glukhov – Brean Murray

Yes, thanks for taking the question. I guess two things, Kelvin, to the extent you are dialing back monetization to increase the longevity of your top two titles, what do you guys see as a longer-term sustainable ARPU level for Perfect World?

Kelvin Lau

I think, right now the market is about RMB 200. But I think as I mentioned many, many times it all depends on how you design the game, how is the game doing. We enjoyed a higher ARPU than some of our peers because we have Chi Bi, which is a very high ARPU game. So, in the long run we try to maintain the ARPU, the stage of Q4, Q3 last year, (inaudible). I think this type of level should be more healthy.

Andrey Glukhov – Brean Murray

Okay. And then to the extent you guys are adjusting the timing on some of your fiscal 2010 releases, how do you, how is that – what impact is that having on the timing of your fiscal '11 pipeline? Are you going to, essentially to the extent the 2D title potential is now shifting into Q1, would you consider adjusting the timing of the releases of titles in fiscal '11? Thank you.

Kelvin Lau

That is what Michael mentioned, I think for Perfect World we are scheduled to launch in Q3, and then Dragon Excalibur most probably early Q4. I think regarding the disclosed the 2-D games, as well Michael mentioned, it all depends on the final development stage. If all things [ph] go smooth, I think we can launch it by the end of this year. If we cannot, most probably we can launch it Q1 after the Chinese New Year.

Andrey Glukhov – Brean Murray

I apologize; I asked whether it's – whether this is impacting the timing of XAJH Meteor, Torchlight and the other games that you plan in fiscal '11?

Kelvin Lau

I think it would not impact our XAJH, because XAJH is 2.5-D game, and (inaudible) is a 2-D game. So, there is no conflict I think between these two games. I think, all the individual teams have been working on the games. I think there is only one objective, is trying to make sure that the game is in high-quality and very good form, before the launch of the game. So I don't see any conflict between these two games, our XAJH and 2-D [ph] games.

Andrey Glukhov – Brean Murray

Great, thank you.

Operator

(Operator instructions) Your next question will come from the line of Adam Krejcik of Roth Capital Partners.

Adam Krejcik – Roth Capital Partners

Yes, hi. Two questions, the first one, Kelvin could you disclose possibly what type of annual revenue C&C Media generated and Runic Games has generated in the last 12 months? Thanks.

Kelvin Lau

Adam, I’m sorry. Our policy is not to disclose for individual companies their revenue forecast or the game performance, I think for each games, individual companies. I think our internal policy is not to disclose some of the details I think for competitive reasons, yes.

Adam Krejcik – Roth Capital Partners

Okay. On the acquisition front, you guys made some acquisitions this past quarter. Are you targeting anything else here in the near-term and you know, if so, what kind of potential opportunities are you looking for? And then also in regards to your cash and uses of cash, any planned share buybacks here? Thanks.

Kelvin Lau

Regarding the M&A projects, I think we keep on looking for good targets, only game development teams, and also some other good business. We are also interested in, but I think all this progress are all related to our core business, online gaming. So I think right now it’s not a very appropriate moment for us to disclose here, I think our targets, but I think once we have finalized the project, we will keep the market informed. I think we will make an announcement.

Regarding the usage of cash, I think as we have mentioned earlier most of our cash would be spent on M&A, this is number one. Number two is on the service acquisition, because we are going to have new game launch. Regarding the share buyback, I think up to now we still haven’t received any permission or approval from the Board, but I think net-net this management’s objective is to use our cash in a best way, yes.

Adam Krejcik – Roth Capital Partners

Okay, thank you.

Kelvin Lau

Welcome.

Operator

Your next question comes from the line of Jin Yoon of Nomura.

Jin Yoon – Nomura

Hi, good evening guys. Sorry, I was kicked off the call so I may be asking a question that was asked before, so I apologize in advance. Kelvin, I think you mentioned or I guess let me ask, the first question is regarding ARPU and the fact that this particular quarter ARPU was up 37% on a sequential basis. And you mentioned some technical difficulties in the quarter you've had with some games. If those games did not see the technical difficulties, how much more expansion in the ARPU would you have seen? Or in reverse, how much of the ACU's or the APC's increase would we have seen? So I just wanted to get to some impact of what that actual technical difficulty is. And I just have a follow-up question regarding ARPU. Thanks.

(Foreign Language)

Vivien Wang

Michael mentioned that actually except for Fantasy Zhu Xian, which encountered some technical competitiveness during Q1 during some of the major updates, actually all of our other games are pretty stable. You know, if we put seasonality factors aside, actually all of our games are performing very stable because as a long-term oriented company, we’re very focused on the growth of our existing games.

In terms of the increase of ARPU, it is actually primarily driven by the increase of ARPU of Perfect World II because we actually did large in-game promotions in Q1. This is actually highly related to the Chinese New Year. Chinese New Year is a very good season for us to do some promotions. So we think this is normal as well. The ARPU level for all the other games are pretty stable. Thank you so much.

(Foreign Language)

Vivien Wang

One more point, actually recently after some of the expansion packs and updates, we’re seeing positive growth of Battle of the Immortals. So actually we’re pretty confident to drive up the user base for Fantasy Zhu Xian again. Thank you.

Jin Yoon – Nomura

Okay, perfect, and, actually, I'll stop there. Thanks.

Vivien Wang

Thanks Jin.

Operator

Your next question comes from the line of Ming Zhao of SIG.

Ming Zhao – SIG

Hi, thank you for taking my questions. The first question is, Michael and Kelvin, can you give us an update about the percentage of pay user as the total users? It seems to me there's a big drop there. Because if you look at the total number of paying user your first quarter is 1.67 million, your third quarter last year is 1.6 million, but ACU is up by 280,000, but the APC is flat between those two quarters, without concern [ph]. But during this period you have launched the Fantasy Zhu Xian. So my question is really why you know, your ACU is up, but your APC is actually flat if you compare 3Q last year and first quarter this year?

(Foreign Language)

Michael Chi

Hi Ming. Thanks for your question. Yes, as we have mentioned, I think Q1 the APC number decreased, I think mainly because of the Chinese New Year. If you’re talking about the conversion rate of the paying account to our – to the registered account [ph]. Right now, according to our data it is about 7% to 9% of the total gamers that are paying customers.

I think if you look at our number as we have mentioned last year Q1, our ACU number and APC number also dropped. I think this is mainly because of the seasonality reason because of the Chinese New Year. So we expect I think Q2 I think ACU and also the APC number will have some rebound, yes.

Ming Zhao – SIG

Okay. Maybe a longer-term question for Michael, Michael, do you think you are going back – you would consider going back to the time-based revenue model in the future? It seems like this item-based model has run to a stage that you know, you and other companies are cutting back the monetization, so I want to hear your comments there.

(Foreign Language)

Vivien Wang

We actually don’t notice any significant trend that that is indicating a shifting back from item-based model to time-based model. Actually, over time we think the increase of ARPU is normal because more and more people are getting used to play and pay on the Internet and with the rise of the consumable income level, we believe actually the ARPU level will go up naturally in the next couple of years.

We haven’t reached a ceiling yet, and naturally speaking the longer the players are playing the game, the higher, the ARPU for that game would be because you know, the longer you play the game, normally the higher or the more you want to spend, and once again the increase of ARPU for those quarters is more because of the Perfect World II, where we did a fair amount of in-game promotions during the Chinese New Year. The ARPU for most of our other games are fairly stable. Thank you.

Ming Zhao – SIG

Thank you very much.

Operator

Your next question and final question comes from the line of Tian Hou of Auriga.

Tian Hou – Auriga

Thank you. Michael, Kelvin, and Vivien, my question is really regarding the deceleration in monetization in Perfect World II in Q2. So, do you see you guys use this method going forward pretty frequent, or is this just a one-time event after you – the promotion program for Perfect World II in Q1?

(Foreign Language)

Vivien Wang

We will actually do in-game promotions and month additions from time to time pretty frequently. Actually our gamers love some of the interesting activities during the in-game promotions and some of that actually indicate that the more the gamer spend in a game that means actually the more they love the game. So we will actually do some of the in-game promotions pretty frequently but you know, after we do some of the large-scale promotions of course, we’ll have to call off a little bit in the following couple of months to make sure the longevity of the game. This is a common technique that we will frequently use. Thanks.

Tian Hou – Auriga

Thank you.

Operator

And do we have any closing remarks.

Vivien Wang

Sure. Thank you. This is the end of the conference call. The web cast replay will be available at Perfect World’s official website, www.pwrd.com under IR section. If you have any additional questions please feel free to contact us. Thank you very much.

Kelvin Lau

Thank you.

Operator

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

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Source: Perfect World Co., Ltd. Q1 2010 Earnings Call Transcript
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