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Executives

Eric He - CFO

Wei Liu - President

Rich Chiang - IR Manager

XueFeng Ji - VP Research & Development

Analysts

Alicia Yap - Citigroup

Atul Bagga - ThinkEquity

Jenny Wu - Morgan Stanley

Gary Ngan - UBS

Giant Interactive Group Inc. (GA) Q1 2010 Earnings Call May 17, 2010 9:00 PM ET

Operator

Good morning, ladies and gentlemen. I would like to welcome everyone to Giant Interactive Group's first quarter 2010 earnings conference call. All lines have been placed on mute to prevent background noise. After the presentation there will be a question-and-answer session. Please follow the instructions given at that time if you would like to ask a question.

Now I would like to transfer the call to the moderator, Mr. Rich Chiang, Investor Relations Manager at Giant Interactive. Please proceed.

Rich Chiang

Good morning, ladies and gentlemen. Welcome to the first quarter 2010 earnings conference call for Giant Interactive Group. With me today are Ms. Wei Liu, President; Mr. Eric He, Chief Financial Officer; and Mr. XueFeng Ji, Vice President of Research and Development. As we proceed through our prepared remarks, we will refer to our results presentation, which can be downloaded from our website at www.ga-me.com. Following the remarks, Ms. Liu, Mr. He, Mr. Ji will be happy to take your questions.

Before we continue, I would like to remind you that statements on this call that are not strictly historical in nature constitute forward-looking statements within the meaning of Section 27(A) of the Securities Act of 1933 as amended, and Section 21(E) of the Securities Exchange Act of 1934 as amended, and as defined in the Private Securities Litigation Reform Act of 1995.

These forward-looking statements can be identified by terminologies such as will, expect, anticipate, future, intends, plans, believes, estimates, and similar statements, and include among others, statements regarding our continued efforts to increase shareholder value through strategic investments and expansion or adjustment of game content and features.

Such forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results of Giant to be materially different from historical results or from any results expressed or implied by such forward-looking statements. These factors include, but are not limited to, risks and uncertainties related to the progress, timing, costs, and results of game testing and product development, competition from other online game companies, and the additional risks discussed in filings with the Securities and Exchange Commission, including our Annual Report on Form 20-F filed on June 19, 2009.

All forward-looking statements are qualified in their entirety by these cautionary statement and Giant undertakes no obligation to revise or update this information to reflect events or circumstances after the date hereof. In addition, please note that references in the presentation to dollars refer to US dollars.

Now, I’d like to pass the call over to Eric He, our Chief Financial Officer.

Eric He

Thank you, Rich. Good morning and good evening, everyone. Thank you for joining us today. In the first quarter 2010, we continue to benefit from the positive trends we began seeing in the fourth quarter 2009, leading to revenue growth of 10.3% from the preceding quarter, we witnessed additional signs of stabilization within ZT Online as players resume in-game spending following the cancellation of the Treasure Box in the mid 2009.

Our new game ZT Online Green Edition continued to ramp up its user base and attracts attention from the players with lower spending habits. Although our profit was adversely impacted by a decrease in financial incentives from the government, which have been anticipated and discussed in the fourth quarter results, we are confident that improving performance of our games will ultimately lead to bottom line expansion. In addition to their promising performance of ZT Online and ZT Online Green Edition, in the first quarter many of our pipeline games remained on track to enter various testing phases in the coming months.

We believe the broad range of games within our portfolio, which offer many innovative game play options allowed us to capture the attention of gamers with a wide range of preferences in China’s growing online game markets. Before getting into more details on the specific of our game portfolio, I’d like to walk you through our operational and financial results for the first quarter.

Our top line expansion in the quarter was the power of our improving operating metrics as shown on slide six. Total Active Paying Accounts or APA expanded to 1,373,000 growing at an impressive 20.6% from the last quarter and growing at 11% from the first quarter in 2009.

Average revenue per user or ARPU declined 8.5% from the fourth quarter 2009 and declined 26.6% from the year ago period to RMB220. Average Concurrent User or ACU was 588,000, a 21.2% sequential increase and 10.8% rise from the first quarter 2009. Peak Concurrent User or PCU was up 15.9% sequentially and up 2.5% year-over-year to $1.611 million.

Though our year-over-year comparison still reflects the impact of our cancellation of Treasure Box in mid-2009, the sequential improvement are evidence that our segmentation strategy and commitment to innovative game plays are successfully attracting new users.

We are making solid headway in our efforts to broaden the number of players within our games, as we believe this will foster a more sustainable and healthy revenue model moving forward.

Moving on to our financial results as shown on slide seven; net revenue for the quarter was $14.6 million representing a 10.3% increase from the fourth quarter 2009 and 18.5% year-over-year decrease.

As mentioned, this sequential top line expansion was attributable to the continued recovery of ZT Online as well as additional contribution from some of our new games mainly ZT Online Green Edition.

Gross profit in the first quarter grew 12% sequentially and declined 17.4% year-over-year to $38 million. This represents a gross margin of 85.2%, an improvement from both the first and fourth quarters of 2009 and attributable to our successful efforts to control costs.

Total operating expenses for the first quarter 2010 were $11.8 million, up 44.9% sequentially, but down 1.4% over the same period last year. The substantial rise over last quarter was due to higher R&D spending coupled with a lower amount of government financial incentives which are treated as a deduction of our operating expenses.

R&D spending increased 22.5% from the last quarter and increased 4.5% from year-ago period, as we hired additional R&D talents to develop new games. Sales and marketing expenses declined 14.9% and 2.1% sequentially and year-over-year respectively as we continue to exercise tight cost control over our liaison personnel and streamline our advertising campaigns compared with a year-ago.

General and administrative expenses fell 23.2% sequentially and fell 13.4% from the first quarter 2009. The sequential decline was also aided by a one-time year-end HR related expenses incurred in fourth quarter 2009, as well as lower consulting fee. The year-over-year decline was the result of management’s tightened expenses control.

Net income attributable to the company's shareholders in the first quarter was down 6.3% sequentially at $27.1 million and declined 20.1% year-over-year. Net margin for the quarter was 60.9%. Basic and diluted earnings per ADS for the first quarter 2010 were both $0.12.

In terms of our balance sheet, as seen on slide nine, as of March 31, 2010 cash, cash equivalents short-term investments and held-to-maturity investment totaled $811.6 million up from $791 million on December 31, 2009.

Last month our Board of Directors also approved a cash dividend of $0.18 per ordinary share payable on May 10 to shareholders of record on April 26. The dividend will represent a pay out of approximately $40.9 million and is representative of our commitment to return value to our shareholders. Of course the strength of these financial results and our future results is and will be primarily driven by the success of our games.

As we discussed at length last quarter, we have assembled a robust and exciting suite of pipeline games aimed at attracting a wider range of gamers and diversifying our revenue stream.

I'm happy to report that our development efforts for these games continue during the first quarter and our games remain on track to launch into various testing phases as scheduled. Notably, ZT Online Green Edition launched into open beta testing towards the end of first quarter 2010 and has recently passed 400,000 PCU. We remain encouraged by the players’ reception of this game as it is evidenced that our segmentation strategy is successfully utilizing the massive popular ZT Online Game brand and content to capture the attention of gamers with a broader range of spending habits.

The Original ZT Online continues to rebound following the Treasure Box cancellation supported by ongoing updates and addition of new features. Development efforts for ZT Online II, the sequel to the flagship game remain on track. As we are focused on making sure that graphics, game plays, characters, and in-game economy are all inline with gamers’ preferences as the game is planning to launch into limited closed beta testing in the third quarter 2010.

Looking beyond our ZT Online franchise, as shown on a slide-12, we have already made significant progress in the development cycle and we are approaching many new milestone in various launches. One particular note, King of Kings III commenced open beta testing in April, initial result has met our expectation, a revised version of Golden Land underwent testing in the second quarter 2010.

Dragon Soul is scheduled to enter into closed beta testing in the third quarter of 2010. In addition to recently further developing new features and next expansion pack for Giant Online, we have also recently signed an agreement to license the game in the Taiwanese market, which will further expand our game’s presence outside the China market.

Within our Win@Giant incubation program, developers continue to gather feedbacks and revise XT Online in anticipation of its closed beta testing launch on this Thursday. We are also continuing our My Sweetie and at same time preparing a 2D turn [ph] based version of the game for the engineering testing in the third quarter.

On the licensing front. we continue to work on preparing Allods Online for the Chinese markets, we’ve also further strengthened our game portfolio with addition of Elsword 3D side-scrolling, advanced casual MMO game developed by South Korea based KOG. We have signed exclusive agreement to operate this game in China and we look forward to initiating engineering testing in the third quarter 2010.

To conclude, the continued recovery of ZT Online and added contribution of ZT Online Green Edition supported our top line expansion in the first quarter. Although the decrease in government financial incentives impacted our bottom line, we are nevertheless encouraged to see a growing number of users and paying gamers within our games.

Looking to the second quarter, we are encouraged by the positive growth momentum in the performance of ZT Online and by contribution from recently launched games and we anticipate continued growth in the second quarter 2010.

Once again, thank you very much for joining us today. We will now be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). And our first question comes from the line of Alicia Yap with Citigroup, go ahead.

Alicia Yap - Citigroup

Two questions, first of all, can you share with us what are some of the features and game plays gamers like in your Green ZT and do you think this can be sustainable and do you think that you may also implement some of lower monetization business model in your future game other than ZT II? And then I have one follow-up.

XueFeng Ji

[Foreign Language]

Rich Chiang

So far based on our currents feedback from our gamers, ZT New Green Edition has been very well received by our gamers, especially those gamers who prefer lots of PK or those who are interested in the economic system as Green Edition has a revived in-game economy compared to previous versions of ZT Online. So, so far it’s been very positive and growing very nicely for us.

XueFeng Ji

[Foreign Language]

Rich Chiang

This in-game economy revenue model has been very successful for us so far. So for future projects and games we will see if it will be also suitable for implementation in those other games as well.

Alicia Yap - Citigroup

Second question, could you give us some color how we should think about the operating margins for second quarter and rest of 2010, as we noted that you have spent some aggressive marketing campaigns to promote your new games starting in April, so will the earnings growth continue to trail behind the revenues growth?

Eric He

Well, Alicia, it’s a good question. As you can see in the first quarter that our operating margin has been held up very well, expect that the government incentive has been a disappointment for us. As you know, the government incentive will be determined by the prior year’s revenues, which is actually the basis for the sales tax that we paid, which a portion of that will be refunded to us in next year.

So I think moving forward, in the rest of the three quarters, I think operating expenses will be determined by two factors, one is the government incentive refund that is the one. The second one will be the spending on operational fronts. On the operational fronts are mainly determined by a couple of factors, one will be the R&D expenses and majorly the other factor will be sales and marketing. The sales and marketing will be really depending on the promise of launching the games.

As you noticed that in the second quarter we have several new launches in the game, which actually will heighten these operating expenses a little higher. So I think that’s inevitable, but however, we have never actually given our forecast for the margin or operating expenses. I will say that when you see that there are more games to be launched or to be in the marketplace, our sales and marketing expenses will go up in tandem [ph] and that's for sure.

On the other hand, our R&D expenses actually are on the rise as well, because R&D personnel or talents are the most important assets of our company, for online game company, that’s the precious assets that we have. So I think we will continue to spend heavily on R&D expenses. So I will expect that R&D expenses will increase steadily, but perhaps not as fast as the first quarter, but I think it will increase modestly in the future.

Alicia Yap - Citigroup

Can I actually follow-up, we saw an increase in sales and marketing, so does that mean that you actually have pretty high expectation on some of these games, so you decided to spend more aggressively?

Eric He

I think sales and marketing expenses were related to somewhat with our expectation on the games. I think you are right, we discussed before that if the game is not to a certain standard we don't even actually roll it out in the marketplace. So yes, to some degree, the sales and marketing budget or expenditure will be highly correlated to the expectation of the game as well.

Operator

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

Atul Bagga - ThinkEquity

A couple of questions. On the industry growth, can you talk about how do you see 2010 shaping up? It seems like couple of your competition have seen not so good near-term outlook? Can you talk about 2010, how does the outlook look to you guys?

Eric He

Atul, you’re talking about the top line, the revenue?

Atul Bagga - ThinkEquity

Yes, top line growth for the industry overall.

Eric He

Okay, I would like to direct this call to our President, Ms. Liu.

[Foreign Language]

Wei Liu

[Foreign Language]

Rich Chiang

For 2010, our outlook on the entire Chinese online game industry is that it's still growing, but maybe at a slower pace than compared to previous years. I think for us, we all think that this year we’ll grow, the industry will grow around 30% or so. For us that means for Giant that we should have to come out with the best games and products that we can. So for 2010, our company should be growing as well and that will be the result of the performance in our existing games, such as ZT Online and new ZT Online Green Edition, plus the new games that we’re trying to launch this year.

Atul Bagga - ThinkEquity

I’m sorry, Rich. So did you say 30% expectation for 2010?

Rich Chiang

For the industry.

Atul Bagga - ThinkEquity

For the industry, okay. And so looking in 2010 and 2011, do you guys expect to maintain your market share? Do you expect to lose some market share in 2010 and gain in 2011? How do you think about your market share in the industry overall?

Eric He

Okay, I would like to direct the questions to our president Ms. Liu.

[Foreign Language]

Wei Liu

[Foreign Language]

Rich Chiang

We hope that our market share will keep increasing.

Atul Bagga - ThinkEquity

Perfect. Just a quick house-keeping question. So, I think you’ve laid a pipeline pretty well for 2010, I was wondering if you can help us understand when do we expect to see revenue contributions from these games in which quarter? Thank you.

Eric He

I am sorry, you say which game?

Atul Bagga - ThinkEquity

The pipeline that’s you laid out, can you talk about when do we start to see…

Eric He

The pipeline...

Atul Bagga - ThinkEquity

…from these games, yes.

Eric He

Are you saying the pipeline? Yes, in fact for the pipeline games, their revenue contribution already start to kick in, but we have to understand when we launched a game initially, their revenue contribution tend to be very minimal and small, because of the fact that lot of game features are not being implemented, that’s number one.

Number two, accounting treatment will require us to recognize revenue on a gradual basis because that we have to use deferred revenue mechanisms to recognize the money spent into the game. So, for example, King of Kings III, XT Online, when they actually open beta and close beta in this quarter, they will start to actually kick in to help us in a revenue stream.

Likewise, in third quarter or the fourth quarter, if ZT II starts to contribute, start to actually -- the beta testing, closed beta testing, they will start to chip-in in revenue for us. But I think for example if ZT II starting in August or September timeframe, they’re going to kick in I think in a later quarter, not exactly the third quarter if they come in on August or September month. So I think normally, when we actually have a beta testing, revenue will start to kick-in but the first quarter usually is very small.

Atul Bagga - ThinkEquity

What about Allods and Elsword?

Eric He

I think we are targeting that Elsword will be beta testing in the third quarter, may be engineering or closed beta testing, may be engineering testing is more, more possible, and closed beta testing will be in the fourth quarter. For Allods, I think, it’s a little complicated game for us, so it may require longer time. I think most likely we will do the technical testing in the fourth quarter, I think in order to expect Allods to chip-in in revenue, we were most likely to look at the first quarter of 11.

Operator

Our next question comes from the line Jenny Wu with Morgan Stanley.

Jenny Wu - Morgan Stanley

Thank you for taking my question. Congratulations for the quarter. My first question is regarding your second quarter revenue growth, you mentioned that you expect a positive growth with second quarter, just wondering what is the revenue contribution? I mean what is the performance you expected for each of the existing games, especially how much you’re budgeting from King of Kings III?

XueFeng Ji

[Foreign Language]

Wei Liu

[Foreign Language]

Rich Chiang

For our second quarter 2010 guidance, our expectations mostly come from [ph] judging the performance of our existing games, mainly the ZT Online series of games. So for King of Kings III, it launched into open beta testing at the end of April, so the significant revenue contribution from that will probably have to wait until third quarter.

Jenny Wu - Morgan Stanley

A related question. For the second quarter’s growth, what’s the trend for the APA and ARPU? Actually what’s the trend of this APA and ARPU for each of your games?

XueFeng Ji

[Foreign Language]

Wei Liu

[Foreign Language]

Rich Chiang

Well, for each of our games, especially the existing games, for our ZT Online the Original version, this version is more suitable for high-end gamers who spend a lot ARPU in this game tends to the higher. For the ZT Online Green Edition, this is targeting lower-end gamers, that are lower spending or non-spending gamers. So ARPU in this game will tend to be lower, but paying player percentage should be higher in this game. So it’s a mix and the operating metrics that we report are the average aggregates of all our games on a companywide basis. So we don’t disclose operating metrics for each game individually.

Wei Liu

[Foreign Language]

Rich Chiang

During the first quarter, we experienced a larger surge in APA and a decline in ARPU mainly due to the ramp up of our ZT Online Green Edition and revenue contribution from that game. But during the second quarter, we expect that things will settle down, ARPU will probably be stable and as our revenue increases will probably come from increase in APA.

Jenny Wu - Morgan Stanley

How about ZT Online, can you update us what’s the ARPU and APA trend for this game?

Eric He

You mean the Original, right? ZT Online Original?

Jenny Wu - Morgan Stanley

Yes, Original ones, yeah.

Eric He

[Foreign Language]

Wei Liu

[Foreign Language]

Rich Chiang

For the Original ZT Online, both ARPU and APA should be pretty steady.

Jenny Wu - Morgan Stanley

Okay, sure. Actually in first quarter, the ZT Online has stabilized. So for second quarter we should see some slight increase at least, is that right?

Eric He

Yes, basically that is correct.

Jenny Wu - Morgan Stanley

Okay, sure. My last question is regarding Green Edition. Can you update us what's the ratio of paying accounts versus the total accounts for this game?

Eric He

Paying account to what?

Jenny Wu - Morgan Stanley

The total account…

Eric He

The active account. [Foreign Language]

I think this paying ratio for ZT Online has been very steady, very constant. Our experience is bouncing between 8% to 10% range.

Jenny Wu - Morgan Stanley

I mean for Green Edition.

Eric He

Green Edition is actually, as President Liu mentioned, it’s a little bit wider. We have not actually given out that numbers yet, I think we’ll give out that number at the appropriate time.

Operator

(Operator Instructions) Our next question comes from the line of Gary Ngan with UBS.

Gary Ngan - UBS

Can you give us a rough sense of what’s the different contribution in terms of percentage revenues for the games? I know you don’t disclose by games, but maybe a sense of what’s old ZT Green and the other games would be?

Eric He

Contribution of, you mean each game? The revenue contribution?

Gary Ngan - UBS

Yes, percentage of revenues, total revenues.

Eric He

Percentage of total revenue.

[Foreign Language]

Wei Liu

[Foreign Language]

Rich Chiang

The majority of our revenue still comes from the ZT Online series of games, roughly about 90%. Out of that chunk, roughly about one quarter is coming from the ZT Online Green Edition.

Gary Ngan - UBS

Thanks. My second question is regarding the Active Paying Accounts and then ARPU. So I remember that the last quarter you’ve mentioned that the ZT Green Edition -- I'm sorry the ZT old edition has already stabilized and this quarter there’s a little bit of increase in spending. So excluding the Green Edition ARPU, how much of an ARPU expansion have you seen during first quarter, is that a large number or is that very, very stable?

Eric He

I would direct this question to President Liu as well.

[Foreign Language]

Wei Liu

[Foreign Language]

Rich Chiang

In the first quarter, our flagship game ZT Online was basically recovering from the Treasure Box cancellation that happened in the second half of last year, so we did experience growth in the performance of ZT Online during the past couple of months and that constitutes both paying players and the ARPU in that conversion.

Wei Liu

[Foreign Language]

Rich Chiang

During the second quarter, we expect that both the performance of the ZT Online to maintain steady growth and for APA and ARPU as well.

Operator

(Operator Instructions) You have a follow-up from Gary Ngan with UBS; go ahead.

Gary Ngan - UBS

Just wanted to ask you, does the PCU of ZT Green of 400,000 include the Tencent service and can you tell us when was that achieved?

Eric He

No, it doesn’t include Tencent’s number.

Gary Ngan - UBS

When was that achieved?

Eric He

When, in the quarter, I don’t exactly remember. I think it’s after the beta testing.

Gary Ngan - UBS

The current run rate is similar to that level, is that the right assumption?

Eric He

Very close, it has been held out very well.

Operator

I show no further questions at this time. I’d like to turn the call back over to management for closing remarks, please proceed.

Rich Chiang

Thank you again for joining us today and we look forward to updating you on our progress in the near future.

Eric He

Thank you.

Wei Liu

Thank you.

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