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Executives

Rich Chiang – IR Manager

Eric He – CFO

Wei Liu – President

Xuefeng Ji – VP of Product Development, Quality Control & Project Management

Analysts

Andrey Glukhov – Brean Murray

Jenny Wu – Morgan Stanley

Thomas Chong – Banc of America/Merrill Lynch

Atul Bagga – ThinkEquity

Adam Krejcik – Roth Capital Partners

Gary Ngan – UBS

Giant Interactive Group Inc. (GA) Q2 2010 Earnings Call Transcript August 9, 2010 9:00 PM ET

Operator

Good morning and good evening, ladies and gentlemen. I would like to welcome everyone to Giant Interactive Group's second 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. (Operator Instructions)

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

Rich Chiang

Good morning, ladies and gentlemen. Welcome to the second 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, and 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 27A of the Securities Act of 1933, as amended, and Section 21E 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 terminology such as will, expects, anticipates, 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 20F filed on June 7th, 2010.

All forward-looking statements are qualified by their entirety by this 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 U.S. dollars.

Now, I would 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. We continued to build positive momentums in second quarter with further improvement in ZT Online and steady ramp-up of players in our newly launched games. These factors ultimately allowed us to deliver a consecutive quarter of top line growth.

Revenue grew 5.7% from last quarter and although our year-over-year comparisons still reflect the impact of the Treasure Box cancellation in the third quarter of 2009, we are nevertheless encouraged by the positive progress in the past several quarters. Our overall player numbers have increased as has the number of paying players within our games, a clear sign that our segmentation and diversification strategies are creating a more stable and suitable – a sustainable revenue base.

As expected, our top line growth is outpacing profit expansion. However, we are confident that as we continue executing on our key initiatives and attract new and former players to our games, our bottom line will stabilize going forward. Supported by the broadening game portfolio, innovative, continuously updated game place, and robust sales and marketing capabilities, we are well equipped to both attract new gamers with varying preferences and keep them engaged. I believe our improving operating metrics are a testimony to this ability.

As seen on the Slide 6, total active paying accounts or APA grew 4.5% sequentially and 19.2% year-over-year to 1.435 million. Average revenue per user or ARPU was 223 renminbi per quarter, which grew 1.4% over last quarter and declined 25.7% over the second quarter in 2009. Average concurrent users or ACU was 670,000, a 13.9% sequential increase and 48% increase from the year-ago period. Peak concurrent users or PCU was up 2.8% sequentially and 15% year-over-year to 1.657 million.

You can see from these key performance metrics that our ZT Online segmentation strategy and portfolio diversification initiatives are clearly moving us toward our objective of creating a healthier and more sustainable revenue model. This increase in overall players and rise in the number of playing accounts are especially important indicators of our successful efforts on this front.

Moving on to our financial results as shown on the Slide 7, net revenue for the quarter was $47.4 million, representing a 5.7% increase from last quarter and 11.7% decrease from the second quarter 2009. As mentioned, the sequential top line expansion was attributable to the continued recovery of ZT Online along with ongoing incremental contribution from some of our new games such as King of Kings III and XT Online.

Gross profit in the quarter grew 6% sequentially and declined 11.2% year-over-year to $40.5 million. This represents a gross margin of 85.4%, representing a very slight improvement on both sequential and year-over-year basis.

Total operating expenses for the quarter were $13.9 million, up 16.6% sequentially and 25.5% over the second quarter 2009. These increases were primarily driven by the additional marketing activities in the quarter to help promote our new games.

R&D spending decreased 1.8% from the last quarter and increased 14.2% from the year-ago period. The year-over rise was mainly driven by the hiring of additional R&D talents. Sales and marketing expenses were up 53.3% sequentially and 87.9% year-over-year due to our increased marketing campaigns for the – for our new games, especially King of Kings III and XT Online.

General and administrative expenses rose 1% from last quarter and fell 19.5% from the second quarter 2009. The sequential increase was due to a one-time consulting fee related to human resources purpose and additional compensation expenses recognized for the new grant of restricted shares. The year-over-year decline was mainly attributable to our ongoing efforts to control expenses.

Net income attributable to the company's shareholders in the second quarter was $27.4 million, representing a 0.4% sequential increase and 19.8% year-over-year decline. As ZT Online continues to rebound and our new games start to gain traction, the rate of bottom line expansion may lag somewhat behind top line growth due to several factors, such as higher sales and marketing expenses for promoting recently launched games. Basic and dilute earnings per share – per ADS' for the second quarter 2010 were both $0.12 each.

Moving to our balance sheet, as seen on the Slide 9, as of March 31st, 2010, cash, cash equivalents, short-term investments, and held-to-maturity investment totaled $810.6 million, down slightly from March 31st, 2010, which reflects the payment of our dividend and cash generated from our operating business.

As part of our ongoing commitment to return value to our shareholders, this month, the Board extended the duration of our share repurchase plan for an additional year in which we are allowed to purchase up to $150 million worth of ADS'.

The improvements seen in our financial results are very much a part of our game performance. We understand that in order to diversify our revenue stream and improve our top line and bottom lines, it is imperative that we cultivate and maintain a game portfolio that appeals to the broad array of gamers. We believe our current games in our pipeline will help us meet this objective and ultimately drive growth within our company.

I am happy to report that during the second quarter, our development initiatives for our various games progressed as planned. Our ZT Online game continues to be main revenue contributor and as I have already mentioned, it is consistently showing signs of recovery and stabilization, in line with our strategy to provide our gamers with new contents, upgrades on an ongoing basis. The new features we have recently introduced with ZT Online are successfully retaining our current base and causing former players to return to the game.

A part of our segmentation strategy, ZT Online Green Edition continues to be well received and is continuing (inaudible) in gamers with various spending habits. We are also very excited about the upcoming launch of ZT II, the sequel to our flagship games into the limited closed beta testing in the fourth quarter this year. We are making sound progress on the development front preparing for this launch and are enhancing the game base – the game based on the feedback we have received from gamers.

Turning to the other games within our portfolio, in the second quarter, we made steady progress in their development cycles and our game remains on track for their various launches and testing stages. With the recent and impending launches of our games, we have initiated several marketing campaigns to help raise the profile of these games among our targeted audiences.

In particular, in the second quarter, we focused our campaigns on King of Kings III and XT Online. We are pleased to report that we are already beginning to see the positive impacts of these efforts as King of Kings III has gained substantial interest from the expanding base of loyal players. Giant Online also celebrates its two years' anniversary this quarter. In honor of this milestone, we held various promotions for the games. We are now planning for a release of Giant Online's next expansion pack in August and the release of the game in Taiwan in September.

XT Online and Dragon Soul also remain on track with R&D teams making ongoing enhancements based on players' feedbacks. There is also being much activities with our Golden Land games. In the second quarter 2009, we started to jointly operate the games with various Internet portals in China to help boost traffic in the games. We exported Golden Land to Taiwan and it has already become one of the highest ranked web games recently in the region. Additionally, we recently license agreements to export Golden Land to Brazil, Turkey, and Japan.

Our two licensed games, Elsword and Allods Online, are both under localizations. We look forward to starting various engineering testing phases on these games later this year.

We progressed as anticipated this quarter from both on operational and financial standpoints. ZT Online continued to show positive signs of recovery and together with added contribution from new games, such as ZT Online Green Edition, King of Kings III, XT Online led to sequential top line growth for the second straight quarter. We believe we are on a solid path to building a more sustainable and stable revenue base, which will ultimately help support healthier profits in the long run.

Looking ahead, we expect many of the trends seen in the recent months to endure with ongoing recovery of ZT Online and increased contribution from our new games. With that said, we anticipate continued top line growth in the third quarter of 2010.

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

Question-and-Answer Session

Operator

(Operator Instructions). And the first question comes from the line of Andrey Glukhov with Brean Murray. Please proceed.

Andrey Glukhov – Brean Murray

Yes. Thank you so much for taking the question. Congrats on a solid quarter. Eric, as you think about the dynamic of APA versus ARPU in the context of kind of continued segmentation of the user base and introduction of ZT2, how do you think ARPU trends are going to look over the balance of the year? Do you think we sort of bottomed out here or do you think that with ZT II, the ARPU can trade somewhat further down?

Eric He

Okay. Let me translate the question to our President, Ms. Liu. Hold on a second.

(Foreign Language)

Wei Liu

(Foreign Language)

(Interpreted) Currently, it looks like our ARPU levels are fairly stable and when we – when we roll out additional games, we hope to increase APA or active paying accounts.

Andrey Glukhov – Brean Murray

Great. And then as you think about the government incentives, you guys had a very healthy spurt in the contribution from the government incentives into the end of the fiscal year last year. Do you think that the trends this year towards Q4 could be somewhat comparable?

Eric He

Well, this government incentive is mainly due to the fact that we got some rebate or refunds from the district government, which is related to the sales tax, so in general, the sales tax to track [ph] with our revenue. As you can see that the revenue for the last year in compared with this, I think it was a little better. So I think in terms of seasonality and pattern, yes, I think toward the fourth quarter, we will get a higher number. I think right now, the second quarter and third quarter is pretty much on track with last year's level.

Andrey Glukhov – Brean Murray

Okay. Thank you very much.

Operator

And the next question comes from the line of Jenny Wu with Morgan Stanley. Please proceed.

Jenny Wu – Morgan Stanley

Hi, Liu, Eric, and Rich. Two questions. For the second quarter, just wondering how much of APA and ACU growth was due to the launch of new games and to the recovery of ZT Online original? Thank you.

Eric He

Let me translate the question first.

(Foreign Language)

Wei Liu

(Foreign Language)

(Interpreted) During the second quarter, our increase in APA and ACU came from both, new games and existing games.

Jenny Wu – Morgan Stanley

Can you just quantify it a little bit?

Eric He

(Foreign Language)

I think, Jenny, it's kind of difficult for us to pinpoint the specific percentage for the reason of competition. So I think we will rather keep this within ourselves.

Jenny Wu – Morgan Stanley

Sure. Just related, for the ZT Online original, we expect is still on the track of a recovery. So for the – and also it's the major revenue contributor for you guys. So what would the APA and ARPU would be like for the second – for the third quarter?

Eric He

You mean for ZT original or for the whole company?

Jenny Wu – Morgan Stanley

Yes, ideally both.

Eric He

Okay.

(Foreign Language)

Eric He

Let me just ask Ji to – Mr. Ji, our VP or R&D, to answer the questions.

Xuefeng Ji

(Foreign Language)

(Interpreted) During the third quarter, our goal is to stabilize ARPU and keep driving active paying accounts.

Jenny Wu – Morgan Stanley

Okay, sure. My last question is about ZT Green Edition. How is the performance of that game so far?

Eric He

(Foreign Language)

Xuefeng Ji

(Foreign Language)

(Interpreted) ZT Online Green Edition is very stable. We recently launched a new – our first expansion pack for that game and we have seen both usage and spending be very healthy and increasing on both our servers and on Tencent servers.

Jenny Wu – Morgan Stanley

Okay. Thank you.

Operator

And the next question comes from the line of Eddie Leung with Banc of America/Merrill Lynch. Please proceed.

Thomas Chong – Banc of America/Merrill Lynch

Hi. This is Thomas calling on behalf of Eddie. Just one quick question. Can you talk about game features of the upcoming new game Dragon Soul? How – when will it be commercial launch and how do you see this game different from ZT Online trends?

Eric He

(Foreign Language)

Wei Liu

(Foreign Language)

(Interpreted) For Dragon Soul, we have two features that make it very distinct within our game portfolio. First is that it's all 3D game. The 3D engine is self-developed by our R&D team located in Chengdu, Sichuan Province, and we believe that this game has very good graphics compared to other games in the marketplace.

Number two is the basic game play of this game is very centered around PK or battles, especially with including PVP features, Player versus Player features; and also focus on team game play with small groups or small teams; not necessarily large-scale battles or large-scale game play compared – as opposed to the ZT games. So this – we believe Dragon Soul will be especially popular with male gamers.

Thomas Chong – Banc of America/Merrill Lynch

I see. Just one quick follow-up question. So when do you expect this game to be commercially launched? Is it by this year or early next year?

Wei Liu

(Foreign Language)

(Interpreted) This Thursday, August 12th, we will be beginning closed beta testing for Dragon Soul. And depending on the feedback from gamers during this phase, we will determine the appropriate promotions or marketing campaigns and the date of open beta testing in the future.

Thomas Chong – Banc of America/Merrill Lynch

I see. Thanks. I will get back to the queue.

Operator

(Operator Instructions). And the next question comes from the line of Atul Bagga with ThinkEquity. Please proceed.

Atul Bagga – ThinkEquity

Hi, guys. Thanks for taking my question and congratulations on the great quarter.

Eric He

Thank you.

Atul Bagga – ThinkEquity

A couple of questions. I wanted to understand how the cost of acquisition might be trending and especially, how do you expect cost of acquisition to trend next year when we are expecting to see a couple of big games which are being pushed out from 2010 to 2011?

Eric He

Atul, you mean the acquisition of customer?

Atul Bagga – ThinkEquity

Right.

Eric He

Okay.

Atul Bagga – ThinkEquity

Customer acquisition costs.

Eric He

Okay. Sure. (Foreign Language)

Wei Liu

(Foreign Language)

(Interpreted) As you mentioned, the industry is getting tougher going forward and costs of acquiring users or gamers is rising. So we are experiencing – we are seeing that sales and marketing expenses and resources are increasing. Therefore, we have our strategy to sort of prioritize which games to promote – we try to promote our best games, and also to come up with different tactics or different ways such as utilizing our sales and marketing liaison personnel on the ground to promote other games as well.

Wei Liu

(Foreign Language)

(Interpreted) We hope to keep sales and marketing expenses as a percentage of our revenue at a reasonable level going forward.

Atul Bagga – ThinkEquity

And just as a follow-up, in second quarter, you – I think you guys mentioned that ZT Green and ZT Online, both the games you saw ACU and APA rise. I'm just trying to understand how much of this increase in APA and ACU is because of new customer acquisition and what percentage of this growth is coming from reduced churn rate.

Eric He

Sure. I would direct this question to our VP or R&D, Mr. Ji.

(Foreign Language)

Xuefeng Ji

(Foreign Language)

(Interpreted) During the second quarter, our increase in APA came from both within ZT Online and ZT Online Green Edition. The introduction of a lot of new features and activities in the game and expansion packs drove some new users into the game.

Atul Bagga – ThinkEquity

Perfect. And last, very quick, if I can squeeze one more. Eric, what should we assume for the tax rate in 2011?

Eric He

2011 – this year will be 11%. Next year, it will be 12%.

Operator

And the next question comes from the line of Adam Krejcik with Roth Capital Partners. Please proceed.

Adam Krejcik – Roth Capital Partners

Hi, thanks for taking my call. I also had some questions on sales and marketing. If you could perhaps just elaborate what's – what are the most effective channels now for marketing games? And I know in the past you had relied a lot on your ground promotion staff, but it seems like the trend is moving away from that. So I was just wondering if you could kind of just talk about what the most effective ways you are seeing in terms of differentiating your games and attracting mind share right now in terms of marketing.

Eric He

Okay. I will direct this question to our President, Ms. Liu.

(Foreign Language)

Wei Liu

(Foreign Language)

(Interpreted) For the online game industry, there is – are several different marketing channels. I guess, traditionally for online games, you would put advertisements online. There are some new channels such as advertisements in SNS websites or a more a viral marketing. There is also traditional media such as television ads that online games are starting to promote in also.

And also of course, the liaison personnel, our sales force on the ground that has been very active by going to Internet cafés to promote our games. But recently, with government regulations discouraging or limiting some activity in Internet cafés, we are seeing that more users may start to play from homes. So we are sort readjusting our strategy, our focus on Internet cafés, but still keeping our sales and marketing liaison personnel to go to other retail locations such as – such as mall, shopping centers, universities, and places like that to remain effective.

Adam Krejcik – Roth Capital Partners

Okay. That's very helpful. And Eric, sales and marketing was about 14% of revenue in the second quarter. Is that a safe kind of run rate to assume for 3Q and 4Q here in that range?

Eric He

Yes. I would do – I would like to direct this question to our President, Liu.

(Foreign Language)

Wei Liu

(Foreign Language)

(Interpreted) During the second quarter, our sales and marketing expenses, as a percentage of revenue, increased due to more marketing campaigns for our new games, such as King of Kings III and XT Online. But during the third quarter, the only new game launch will be closed beta testing for Dragon Soul. So the marketing expenses should decrease somewhat compared to the previous quarter. Going forward, over a longer term, we hope to maintain sales and marketing expenses, as a percentage of revenue, within 10% to 15% of revenue.

Adam Krejcik – Roth Capital Partners

Okay. Thank you very much.

Eric He

Thank you, Adam.

Operator

And the next question comes from the line of Gary Ngan with UBS. Please proceed.

Gary Ngan – UBS

Thank you for taking my questions. The first question is, can you give us a sense of what's the breakdown of revenues for this quarter? So – for example, what does ZT original account for total revenues and what does ZT Green account for total revenues as a percentage?

Eric He

I would like to direct this call to Ms. Liu.

(Foreign Language)

Eric He

I think Gary, as you know, that in general, we do not actually break down the detailed numbers for this original and Green version and the rest. But I would say that at current time, our – bulk of our revenues still come from ZT series. I think ZT series, including original, Green version, classics account for a very big chunk, close to 90%. So the rest actually is less. Among the ZT series, the largest portion is still from ZT original. So I think that's as far as I can tell you at this moment.

Gary Ngan – UBS

Sure. Thank you. And the other question is just – because I just want you help us to understand more how does the two, ZT original and Green Edition, compare. So – let's say for example, a given level of player traffic, let's say a 100,000 ACU, what is sort of the difference in terms of revenue that the two games can generate? So is that going to be ZT original being two times higher than ZT Green or how should we think about that?

Eric He

Okay. I would like to direct these questions to our VP of R&D, Mr. Ji.

(Foreign Language)

Xuefeng Ji

(Foreign Language)

(Interpreted) For the same user levels in each game, the ARPU level in Green Edition would be lower than ZT original, but a little bit higher than what we originally anticipated.

Gary Ngan – UBS

Okay. Thank you very much.

Operator

And the next question comes from the line of Alicia Yap with Citigroup. Please proceed. My apologies. There are no questions at this time.

Ladies and gentlemen, this concludes the question-and-answer session for today's call. I would now like to turn the call over to Mr. Rich Chiang for closing remarks.

Rich Chiang

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

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect.

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